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MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons Background Paper by Kunio Okina, Masaaki Shirakawa, and Shigenori Shiratsuka Since the latter half of the 1980s, Japan’s economy has experienced the emergence, expansion, and bursting of a bubble economy, characterized by a rapid rise in asset prices, the overheating of economic activity, and the expansion of money supply and credit. This paper examines the mechanism by which the bubble economy was generated and summarizes lessons a central bank should draw from the experience in order to prevent it from happening again. Specifically, by focusing on the intensified bullish expectations that played an important role behind the large fluctuations in asset prices and the economy, the process of the emergence, expansion, and bursting of the bubble is examined in relation to the monetary policy at the time. Based on this analysis, the paper discusses a framework for monetary policy conducive to achieving both price stability and financial system stability. Key words: Asset prices; Bubble; Intensified bullish expectations; Monetary policy; Sustained price stability; Financial stability; Forward-looking monetary policy Kunio Okina: Bank of Japan (E-mail: [email protected]) Masaaki Shirakawa: Bank of Japan (E-mail: [email protected]) Shigenori Shiratsuka: Bank of Japan (E-mail: [email protected]) This paper is a revised version of preliminary draft presented at the workshop under the same title sponsored by the Institute for Monetary and Economic Studies at the Bank of Japan on January 25, 2000. The authors are grateful to Dr. Masaru Yoshitomi, Professor Shinichi Kitasaka, and other participants at the workshop for their helpful comments and discussions; to Messrs. Yasuhiro Maehara, Michio Kitahara, Toyoichiro Shirota, and Yuji Yokobori, and Ms. Sachiko Suematsu for their assistance. The views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan. 395 I. Introduction Japan’s economy has experienced substantial fluctuations since the latter half of the 1980s. From the latter half of the 1980s to the early 1990s when the bubble emerged and expanded, we saw a rapid and large surge in asset prices, a sizable increase in money supply and credit, and the expansion of economic activity for a protracted period. During the subsequent period of the bursting of the bubble from the early 1990s, Japan experienced a plummet in asset prices, the accumulation of huge nonperforming assets and resulting difficulties faced by financial institutions, and a prolonged recession. There have been various discussions and analyses among central bankers, academia, and economists both at home and abroad with respect to the mechanism of how the bubble economy was generated, although up to now a consensus is far from being reached.1 Similarly, discussions are under way as to how monetary policy should be conducted when asset prices rapidly rise. In fact, the evaluation of monetary policy depends very much on financial and economic conditions under which it is conducted. For example, from the latter half of 1987 when asset prices rapidly rose and economic expansion became increasingly certain, the Bank of Japan (BOJ) explored the possibility of monetary tightening in view of concern over inflation and excessive monetary easing, but could not present an argument that was regarded as sufficiently convincing for tightening. In contrast, immediately after the bursting of the bubble, there were periods when monetary tightening was generally praised as an appropriate measure. As the recession became protracted, the BOJ was exposed to severe criticism that prolonged monetary easing since the latter half of the 1980s had brought about the bubble economy, which led to the subsequent deep recession and nonperforming-asset problem. Recalling the situation when the bubble emerged, the BOJ expressed concern, at a relatively early stage, over inflationary pressure and the adverse effects of excessive monetary easing. Such concerns were also shared by not a few economists at that time. However, in view of stable prices indicated by various related indices, those who were concerned with inflationary pressure had difficulty in reconciling stable price indices with concern over future inflation. Furthermore, there did not exist a commonly shared understanding as to what exactly are problems caused by the increase in asset prices. This paper intends to draw lessons based on the experience of monetary policy during the bubble period rather than a simple afterthought. In view of such an intention, this paper attempts to describe as accurately and as concretely as possible the economic, financial, and social background under which monetary policy was being conducted. Needless to say, the lessons derived from the experience during the bubble period could differ depending on the economic theories that are being applied and also on how the general public perceived the central bank. Some may find this paper overstates the importance of monetary policy and others find it 1. Literature that has dealt with Japan’s bubble period includes Ohta (1991), Noguchi (1992), Ueda (1992), Iwata (1993), Ministry of Finance (1993), Suzuki (1993), Takao (1994), Ogata (1996), Cargill, Hutchison, and Ito (1997), Ogawa and Kitasaka (1998), Yoshitomi (1998), Okumura (1999), and Mieno (2000). 396 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons too detached or self-defensive, neither of which intention the authors had in mind. The main purpose of this paper is to present the authors’ views on the cause of the bubble since the late 1980s and the lessons for monetary policy as well as to objectively describe the background behind these views, thereby further enriching discussion on the bubble. This paper is structured as follows. Chapter II reviews the development of Japan’s economy during the bubble period, and Chapter III examines the mechanism behind the emergence and expansion of the bubble. Chapter IV analyzes how monetary policy was conducted in the process of the emergence and expansion of the bubble as well as the influence of prolonged monetary easing on the process. Chapter V considers the question of why monetary tightening was delayed, and Chapter VI discusses the lessons learned from the bubble period that the BOJ should be aware of in conducting monetary policy. II. Overview of Japan’s Economy during the Bubble Period A. Definition of the Bubble Economy While the term “bubble” is used differently among people, based on the experience of Japan’s economy in the late 1980s, let us characterize the bubble economy in this paper by three factors: a rapid rise in asset prices, the overheating of economic activity, and a sizable increase in money supply and credit (see Figure 1 for monetary and economic conditions after the 1980s). The definition of the bubble period may vary depending on which one of the three factors one emphasizes. The rise in asset prices started around 1982 and accelerated from 1985 to 1986. However, the rise was relatively moderate in the early stage and two years (1985–86) coincided with the “endaka recession” (a recession caused by the appreciation of the yen). While few view these years as being part of the bubble period, many consider 1987 as the beginning of the bubble period for the following reasons. First, according to the Economic Planning Agency’s (EPA) reference dates of the business cycle, the economy bottomed out in November 1986 and 1987 was a year of expansion. Second, while the year-on-year growth rate of money supply (M2+CDs) and credit had been declining somewhat in 1986, albeit at a high level, it started to accelerate around 1987. As such, 1987 saw an accelerating rise in money supply and credit, a rapid increase in asset prices, and the economy entering a recovery cycle. Hence, many naturally regard 1987 as the starting year of the bubble. However, some might argue that 1987 should not be included in the bubble period since the recovery of the economy was not clearly recognized in the first half of the year and there was a worldwide stock market crash in October of the same year. Views differ as to when the bubble began to burst. Stock prices in terms of the Nikkei 225 peaked at end-1989,2 while land prices in terms of the Urban Land Price Index (six major cities, commercial areas) of the Japan Real Estate Institute peaked 2. The Nikkei OTC Index hit a peak on July 9, 1990, increasing almost 60 percent even after the Nikkei 225 peaked at end-1989 (from ¥2,597 at end-1989 to ¥4,149 on July 9, 1990). 397 Figure 1 Financial and Macroeconomic Conditions Percent Yen/U.S. dollar 8 7 6 5 4 3 2 1 0 275 250 225 200 175 150 125 100 75 Official discount rate (left scale) Yen/U.S. dollar rate (right scale) 1982 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 Changes from a year earlier, percent 14 12 10 8 6 4 2 0 –2 –4 Claims on private sector M2+CD 1982 83 84 85 86 87 88 89 90 91 92 93 94 95 96 ¥ thousands 97 98 99 1990/III = 100 40 35 30 25 20 15 10 5 0 120 Nikkei 225 (left scale) Commercial land price index of cities (right scale) 80 60 40 20 0 1982 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 Percentage points Changes from a year earlier, percent 8 80 6 60 4 40 2 20 0 0 –2 –20 Real GDP growth (left scale) Business conditions DI (right scale) –4 –40 –60 –6 1982 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 Changes from a year earlier, percent 4 2 0 –2 Domestic WPI CPI excluding fresh foods –4 –6 1982 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 Notes: Shaded areas indicate periods of economic recession. Sources: Bank of Japan, Financial and Economic Statistics Monthly; Economic Planning Agency, Annual Report on National Accounts; Japan Real Estate Institute, Urban Land Price Index. 398 100 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons around 1990. In addition, the year-on-year growth rate of money supply (M2+CDs) peaked in April and May 1990, and the economy peaked in February 1991 according to the EPA. While the exact period of the emergence, expansion, and bursting of the bubble may differ, in this paper we define the four years from 1987 through 1990 as the “emergence and expansion of the bubble period” based on the simultaneous rise in stock and land prices, economic activity, and money supply.3 B. Characteristics of the Bubble Economy 1. Substantial increase in asset prices The first characteristic of the bubble period was a rapid and substantial rise in asset prices. In fact, asset prices began increasing in 1983, and it was around 1986 when the rise began accelerating rapidly. Among asset prices, what exhibited the most rapid rise initially were stock prices. The speed of the rise in the Nikkei 225 began accelerating in 1986 and the index hit a peak of ¥38,915 at end-1989, 3.1 times higher than the level at the time of the Plaza Agreement in September 1985 (¥12,598). Then, stock prices fell sharply to ¥14,309 in August 1992, more than 60 percent below the peak.4 The rise in land prices followed that in stock prices with a time lag, spreading from Tokyo to major cities such as Osaka and Nagoya, and then to other cities (Figure 2). The Urban Land Price Index reached a peak in September 1990, almost four times higher than the level in September 1985. Land prices have been declining thereafter and in 1999 were some 20 percent lower than in September 1985, and some 80 percent lower than the peak in September 1990. Since the end of World War II Japan has seen a number of substantial rises in land prices, but the rise during the bubble period was the greatest since the mid-1950s (when statistics became available) in terms of both the inflation-adjusted rate of increase and its duration (Figure 3). In terms of fluctuations in asset values, the combined capital gains on stocks and land were 452 percent of nominal GDP for the 1986–89 period, which was much higher than the 193 percent recorded for the 1972–73 period. The capital losses were 159 percent of nominal GDP for the 1990–93 period (Figure 4).5 2. Overheating of economic activity The second characteristic of the bubble period was the overheating of economic activity. According to the EPA, the economy hit a bottom in November 1986 and 3. A bubble period can also be defined as a period during which actual asset prices exhibit substantial upward divergence from an equilibrium price calculated from theoretical models. Such a method was not adopted in this paper since the equilibrium price critically depends on the assumptions underlying the theoretical model. 4. Stock prices subsequently showed a temporary rebound, but declined further to ¥14,485 in 1995 against the backdrop of the yen’s appreciation. Stock prices recently recorded a bottom of ¥12,879 in October 1998 (67 percent below the peak). 5. In our calculation, the ratio of each year’s capital gains (losses) to nominal GDP is simply added up. Capital gains during the bubble period were substantially greater than capital losses following the bursting of the bubble. This is largely attributable to Japan’s land utilization structure, where agricultural land and forests have been consistently converted into residential and commercial areas. The average land price in residential and commercial areas is more than 30 times that of agricultural land and forests, and thus conversion to residential and commercial use increases Japan’s average land prices. 399 Figure 2 Land Prices by Use and Area [1] Commercial Land 100 Changes from a year earlier, percent 80 Nationwide Six major cities Tokyo 60 40 20 0 –20 –40 1984 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 [2] Residential Land 100 Changes from a year earlier, percent 80 Nationwide Six major cities Tokyo 60 40 20 0 –20 –40 1984 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 Source: Japan Real Estate Institute, Urban Land Price Index. Figure 3 Real Land Prices Changes from a year earlier, percent 70 60 Nominal growth rate 50 Real growth rate 40 30 20 10 0 –10 –20 –30 1955 58 61 64 67 70 73 76 79 82 85 88 91 94 97 Note: Real land prices correspond to the commercial land prices in six major cities deflated by the GDP deflator. Sources: Japan Real Estate Institute, Urban Land Price Index; Economic Planning Agency, Annual Report on National Accounts. 400 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons Figure 4 Capital Gains and Losses [1] Land and Stocks Ratio to nominal GDP, percent 150 (+193%) (+452%) 100 50 0 –50 (–159%) –100 1956 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 [2] Land 150 Ratio to nominal GDP, percent (+367%) (+156%) 100 50 0 –50 (–107%) –100 1956 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 [3] Stocks 150 Ratio to nominal GDP, percent 100 50 (+36%) (+151%) 0 –50 (–110%) –100 1956 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 Source: Economic Planning Agency, Annual Report on National Accounts. 401 then expanded for four years and three months (51 months) until February 1991, after which it subsequently slowed down until October 1993. The economic expansion during the bubble period is the second longest after the expansion of the late 1960s (Izanagi Boom),6 and real GDP and industrial production grew at an average annual rate of 5.5 percent and 7.2 percent, respectively. The main engine behind such economic expansion was business fixed investment, which continued to be almost 20 percent of GDP, a level comparable to that during the high economic growth period of the 1960s (Figure 5). In addition, there was a large increase in housing investment and also in expenditure on consumer durables on the part of the household sector (Figure 6). In contrast, during the recession after the bursting of the bubble, the economic slowdown lasted 32 months (from February 1991 to October 1993), the second longest slowdown following that after the second oil shock (36 months, from Figure 5 Fixed Investment and Nominal GDP Ratios 25 Ratio to nominal GDP, percent 20 15 10 Iwado Boom 5 Izanagi Boom Heisei Boom 0 1957 60 63 66 69 72 75 78 81 84 87 90 93 96 93 96 Note: Shaded areas indicate periods of economic recovery. Source: Economic Planning Agency, Annual Report on National Accounts. Figure 6 Real Expenditure by Households 50 Changes from a year earlier, percent 40 30 20 10 0 –10 –20 Real durable goods expenditure Real residential investment –30 1957 60 63 66 69 72 75 78 81 84 87 90 Note: Shaded areas indicate periods of economic recovery. Source: Economic Planning Agency, Annual Report on National Accounts. 6. The economic expansion during the Izanagi boom lasted for 57 months from October 1965 to July 1970. 402 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons February 1980 to February 1983). Average annual real GDP growth during this period was only 0.8 percent and industrial production declined 5.2 percent annually. 3. Increase in money supply and credit The third characteristic of the bubble period was the sizable expansion of money supply and credit. The growth of money supply (M2+CDs) somewhat decelerated in 1986 (the lowest growth rate was 8.3 percent in October–December 1986), but gradually accelerated afterwards and exceeded 10 percent in April-June 1987 (Figure 7). The growth of credit was more conspicuous than that of money supply. During the bubble period, not only bank borrowing but also financing from capital markets substantially increased against the backdrop of the progress of financial deregulation and the increase in stock prices (Figure 8). As a result, the funding of the corporate and household sectors (the sum of bank borrowing, straight corporate bonds, convertible bonds, bonds with warrants, and equity increase) rapidly increased from around 1988 and recorded a rate of growth close to 14 percent on a year-on-year basis in 1989 (Figure 7). Figure 7 Monetary Aggregates and Credits 14 Changes from a year earlier, percent M2+CD Broadly-defined liquidity Fund-raising by the domestic nonfinancial sector 13 12 11 10 9 8 7 1986 87 88 89 Source: Bank of Japan, Financial and Economic Statistics Monthly. Figure 8 Fund-Raising in Capital Markets by the Private Sector 30 ¥ trillions Bonds with warrants Convertible bonds Straight bonds Stocks 25 20 15 10 5 0 1980 81 82 83 84 85 86 87 88 89 90 91 92 Note: Figures correspond to funding by companies listed on the Tokyo Stock Exchange. Source: Tokyo Stock Exchange. 403 C. Size of Japan’s Bubble Economy From the latter half of the 1980s, a bubble economy emerged not only in Japan but also in other industrial countries. Indeed, economic and financial history both at home and abroad shows that bubbles have often emerged. Thus, to put the size of the bubble economy in Japan into perspective, it may be useful to compare it with bubbles in other industrial countries in the 1980s as well as the experience in Japan after World War I (WWI). 1. Comparison with overseas episodes Looking at the experience of major countries from the latter half of the 1980s, stock prices started to rise from around 1983 and, until mid-1987, it was not necessarily the case that such a rise was only conspicuous in Japan (Figure 9). However, from 1988 the stock price rise in Japan began to stand out internationally. Borio et al. (1994) concluded that the rate of increase in real asset prices (both stock and land prices) in Japan was quite high as were the increases in Sweden and Finland (Figure 10).7 From the latter half of the 1980s, Japan experienced the largest fluctuation in economic activity among industrial countries. Though the timing of the bubble period differs slightly from country to country, when one compares economic growth of the G-7 countries between 1986–90 (the bubble period) and 1991–95 (the bursting of the bubble period) its fluctuation was the largest in Japan. Many countries had observed an increase in nonperforming assets since the latter half of the 1980s, among which the nonperforming assets of Japanese financial institutions were the largest. Nonperforming assets of major Japanese banks were Figure 9 International Comparison of Stock Price Movements 3.0 End-1981 = 0 log-scale MSCI/World Nikkei 225 New York Dow 2.5 2.0 1.5 1.0 0.5 0.0 –0.5 1982 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 Note: MSCI/World corresponds to aggregated stock price index in 22 industrialized countries compiled by Morgan Stanley Capital International. Sources: Bank of Japan, Financial and Economic Statistics Monthly; Morgan Stanley Capital International (http://www.msci.com). 7. Real aggregate asset prices estimated by Borio et al. (1994) were updated until 1997 by BIS (1999). The prices are the weighted average of equity and residential and commercial real estate price indices deflated by consumer prices with the weights based on the composition of private-sector wealth. 404 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons Figure 10 Real Aggregated Asset Prices 1980 = 100 1980 = 100 300 300 United States Japan France United Kingdom Canada 250 Netherlands 250 Finland Australia 200 200 150 150 100 100 50 1970 72 74 76 78 80 82 84 86 88 90 92 94 96 Sweden 50 1970 72 74 76 78 80 82 84 86 88 90 92 94 96 Note: Real aggregate asset price indices are a weighted average of equity and residential and commercial estate price indices deflated by consumer prices. The weights are based on the composition of private-sector wealth. Source: Bank for International Settlements (1999). ¥20.3 trillion (4.1 percent of nominal GDP) at end-March 1999 and reached ¥44.6 trillion (9.0 percent of nominal GDP) if the accumulated direct write-offs from fiscal 1992 are added (Figure 11).8 Granted that it is difficult to make an accurate comparison, but if we take into account the size of public funds injected and large fluctuations in asset prices, we may be able to conclude that the bubble in Japan in the late 1980s, like those in the Nordic countries, was extremely large.9 8. It is difficult to make a precise international comparison of the nonperforming assets of financial institutions. For example, nonperforming assets in the United States (for member banks of the Federal Deposit Insurance Corporation) increased from 1990 to 1991, reaching US$117 billion (2.0 percent of nominal GDP) in the second quarter of 1991. If one adds the amount of direct write-offs in each quarter after the fourth quarter of 1986 when nonperforming assets began to increase, the accumulated amount of nonperforming assets was US$252.2 billion (4.1 percent of nominal GDP) in the third quarter of 1992. 9. In Sweden and Finland, public funds were injected to dispose of nonperforming assets in the banking sector on the scale of 4.7 percent (1991–93) and 7.3 percent (1991, 1992) of nominal GDP, respectively (BIS [1993]). In Japan, financial reconstruction legislation passed by the Diet in October 1998 provided ¥60 trillion (12 percent of nominal GDP) in public funds to dispose of nonperforming assets in the banking sector. The figure will be increased to ¥70 trillion (14 percent of nominal GDP) when legislation related to revision of the Deposit Insurance Corporation passes the Diet. 405 Figure 11 Nonperforming Loans of Banks [1] Amounts Outstanding 50 45 40 35 30 25 20 15 10 5 0 ¥ trillions Accumulated direct write-offs Risk management loans Outstanding amount of specific allowance for loan loss Mar. 1993 Mar. 94 Mar. 95 Mar. 96 Mar. 97 Mar. 98 Mar. 99 Sep. 99 [2] Ratio to Nominal GDP 10 9 8 7 6 5 4 3 2 1 0 Ratio to nominal GDP, percent Accumulated direct write-offs Risk management loans Mar. 1993 Mar. 94 Mar. 95 Mar. 96 Mar. 97 Mar. 98 Mar. 99 Sep. 99 Notes: 1. Figures are summations of city banks, long-term credit banks, and trust banks. (Figures for all banks and all deposit-taking institutions are impossible to retroact before fiscal 1995.) 2. Risk management loans are summations of loans to borrowers in legal bankruptcy, past due loans in arrears by six months or more, and loans in arrears by three months or more and less than six months. Source: Financial Services Agency (http://www.fsa.go.jp). 2. Comparison with the bubble after WWI Comparing the change in asset prices between the bubble period in the latter half of the 1980s and the one after WWI (1914–18),10 while the rate of increase and decrease in stock prices was not different, the speed of decline after the bubble burst 10. At that time, Japan’s economy had been stagnant for a while after the outbreak of WWI, and from mid-1915 started to recover thanks to a rapid increase in exports, converting the trade balance into a large surplus (so-called special war demand). The economy fell into a temporary recession after the end of WWI in November 1918, bottomed out in March 1919, and entered a boom phase with a rapid rise in land and stock prices. Economic expansion was supported by a buoyant U.S. economy, reconstruction demand in Europe, and an expansionary fiscal and monetary policy. However, in 1920, while imports continued to increase, exports declined due to the accumulative effect of inflation and the trade balance turned to a deficit. As a result, foreign exchange reserves and money supply decreased and the economy followed a downward trend. Under such circumstances, the stock market crashed on March 15, 1920, which added a further blow to the already stagnant economy. 406 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons was somewhat faster in the period after WWI (Figure 12). And the rate of increase in land prices was also larger. Regarding capital gains and losses, for which an estimate only exists for those on land, capital gains reached 335 percent of GNP Figure 12 Comparison of Bubbles: 1920s and 1980s [1] Stock Prices [2] Land Prices 120 120 100 100 80 80 60 60 40 40 Bubble period 20 20 Bubble period 1920 depression 0 1920 depression 0 –36 –30 –24 –18 –12 –6 0 6 12 18 24 30 –36 –30 –24 –18 –12 –6 0 [3] Aggregate Output [4] Consumer Prices 125 120 120 110 115 100 110 90 105 80 100 70 95 60 90 50 85 40 80 6 12 18 24 30 30 75 Bubble period 20 Bubble period 70 1920 depression 10 1920 depression 65 0 –36 –30 –24 –18 –12 –6 0 6 12 18 24 30 120 100 80 60 40 Bubble period 1920 depression 0 –36 –30 –24 –18 –12 –6 0 6 12 18 24 30 Notes: 1. All figures are quarterly and normalized as 100 at the time of peak in stock prices 1989/IV for bubble period and 1920/I for 1920 depression. 2. Regarding aggregate output, real GDP for the bubble period, and real GNP for the 1920 depression. [5] Monetary Aggregates 140 20 –36 –30 –24 –18 –12 –6 0 6 12 18 24 30 Sources: Bank of Japan, Financial and Economic Statistics Monthly, Hundred-Year Statistics of the Japanese Economy, Nihon Kin’yu Shi Shiryo (Collected Material for Japanese Financial History); Economic Planning Agency, Annual Report on National Accounts; Ministry of Finance, Kin’yu Jiko Sankosho (Reference for Major Events of Financial Markets); Takayoshi Asakura and Chiaki Nishiyama, eds. Nihon Keizai no Kahei Teki Bunseki 1868–1970 (Monetary Analysis of Japanese Economy 1868–1970). 407 during 1913–19, and capital losses 43 percent of GNP during 1924–30 (Table 1). In the case of the recent bubble period, capital gains on land were 367 percent of GDP during the bubble period, and capital losses 107 percent of GDP after the bursting of the bubble, evidence that capital losses were substantially larger in the recent bubble period. If one looks at the development of the economy and prices after the bursting of the bubble, the extent of the decline was much smaller in the recent bubble period. According to the EPA, the economy hit its recent bottom in October 1993, although real GDP for the fourth quarter of 1993 slightly exceeded that of the first quarter of 1991, the recent peak of the business cycle. In contrast, after WWI, real GDP had increased for about two years after stock prices had hit a peak, and then declined sharply. Prices as well as stock prices hit a peak in the first quarter of 1920 and then declined more than 20 percent toward 1921, while the recent bubble period did not witness any significant price decline. In sum, compared with the bubble period after WWI, the magnitude of the asset bubble was larger in the bubble period of the late 1980s, but the decline in economic activity after the bursting of the bubble was smaller.11 Table 1 Capital Gain/Loss in Land Assets (Comparison with Past Episodes) Ratio to nominal GDP (GNP), percent World War I “Remodeling the Japanese Archipelago” Bubble period 1913–19 1919–24 1924–30 1930–35 1972–73 1986–90 1991–93 335 1 –43 –26 165 367 –107 Notes: 1. Figures for capital gains and losses are on land stocks. 2. National wealth statistics before World War I are discontinuous. 3. Figures for World War I are ratio to nominal GNP. Sources: Bank of Japan, Hundred-Year Statistics of the Japanese Economy ; Economic Planning Agency, Annual Report on National Accounts. III. Mechanism behind the Emergence and Expansion of the Bubble A. Intensified Bullish Expectations The following are often pointed out as factors behind the emergence and expansion of the bubble: • Aggressive behavior of financial institutions • Progress of financial deregulation • Inadequate risk management on the part of financial institutions • Introduction of the capital accord 11. While it is difficult to compare the amount of nonperforming assets due to lack of data around the time of WWI, the large capital losses mentioned above suggest that substantially larger nonperforming assets were generated during the recent bubble period. 408 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons • Protracted monetary easing • Taxation and regulations biased toward accelerating the rise in land prices • Overconfidence and euphoria • Over-concentration of economic functions on Tokyo, and Tokyo becoming an international financial center These factors are not necessarily mutually exclusive, but interrelated. In this regard, we are often tempted to ask: among these factors, can we single out the most important and fundamental factor to explain the emergence and expansion of the bubble? Unfortunately, there is no simple answer to this question. Our experience after the late 1980s tells us that realities cannot be explained by any one factor. Our conclusion is that no single factor was responsible for generating the bubble. Rather, we believe that when several initial factors changed, there existed certain factors amplifying such changes, which led to the emergence and expansion of the bubble. The bubble was generated by the complex interaction of various factors in a similar way as in a chemical reaction. The process of such a chemical reaction could be termed the process of “intensified bullish expectations.” With intensified bullish expectations as our central analytical concept, we discuss the bubble-generating mechanism by examining factors that are considered to affect such expectations (Figure 13). Figure 13 Illustration of the Bubble Economy in Japan Overheated economic activities Rise in asset prices Expansion of monetary aggregates and credits Intensified bullish expectations (Initial factors) Aggressive bank behavior • Gradual financial deregulation • Declining profitability • Monetary easing (Amplifying factors) Protracted monetary easing • Overestimation of endaka recession • Stable measured inflation Land tax system and regulation (Policy agenda of the era) • International policy coordination • Prevention of the yen’s appreciation • Reduction of the current account surplus through the expansion of domestic demand • Fiscal consolidation Weak mechanism to impose discipline • No bankruptcy of financial institutions • Accounting system • Insufficient disclosure Self-confidence in Japan • Outstanding economic performance • Largest creditor country • Confidence in Japanese-style management • Tokyo as an international financial center 409 First of all, let us examine when and to what extent such bullish expectations became intensified. In the latter half of the 1980s, Japan’s economy was experiencing a recession due to the rapid appreciation of the yen after the Plaza Agreement, and both business and household sentiment was, up to a certain point in time, extremely bearish. After some point, however, bullish expectations became dominant among many economic agents such as firms, households, financial institutions, and the government. Though it is difficult to quantify the extent of such bullish expectations, we may be able to use the change in the yield spread of stocks as a proxy. The yield spread of stocks can be calculated by subtracting the yield on stocks (expected profits/share price) from long-term interest rates. It is equal to the difference between expected growth rate and risk premium, and thus becomes a measure for bullish expectations in that it represents the expected growth rate adjusted for risk premium.12 The yield spread of stocks shrank below 2 percent at the beginning of 1987, but rebounded from around 1988, expanding to some 6 percent in 1990 (Figure 14). The expansion of the yield spread during this period implies that the expected growth rate increased, or risk premium decreased, or both happened simultaneously. If we assume a risk premium of 2 percent,13 the expected growth rate of nominal GDP in 1990 would have been as high as 8 percent. However, in view of low inflation at the time, it is almost impossible to believe that the potential growth rate of nominal GDP was close to 8 percent. Hence, it would be more natural to infer that the high level of the yield spread in 1990 reflected the intensification of bullish expectations. Figure 14 Equity Yield Spreads 10 8 6 Percent Yield spread Price-earning ratio Long-term interest rate 4 2 0 –2 1981 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 Notes: 1. Yield spread and price-earning ratio are computed on TOPIX basis. 2. Long-term interest rate is JGB (10-year) at the end of each month. Source: Bank of Japan, Financial and Economic Statistics Monthly. 12. It is not necessarily important to distinguish between the increase in expected growth rate and the decrease in risk premium, since both will have an impact on asset prices in the same direction. For example, if a rise in the yield spread of stocks reflects a decline in risk premium, it suggests stronger confidence for the future, and corporate and household economic activity will become active as the expected growth rate increases. Hence, when considering the effects on asset prices, it suffices to evaluate the expected growth rate which is adjusted for risk premium. 13. Risk premium can be calculated as follows. For example, if one takes the difference between the average annual nominal growth rate for the 10 years 1984 through 1993 (5.3 percent) and the average yield spread (3.4 percent), it is 1.9 percent. If one takes the difference between the nominal growth rate of 1994 (6.9 percent) when the declining trend of nominal GDP came to a halt and the yield spread of the same year (4.5 percent), it is 2.4 percent. 410 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons B. Factors behind the Bubble Through what mechanism was the bubble generated? With focus on intensified bullish expectations, we examine the following five factors that are considered important: aggressive bank behavior, protracted monetary easing, taxation and regulations biased toward accelerating the rise in land prices, a weak mechanism to impose discipline, and the effect of overconfidence in Japan.14 Though these five factors are mutually interrelated, if we dare to point the finger at one, it would likely be the aggressive behavior of financial institutions, which indeed many consider to be the initial underlying factor behind the emergence of the bubble, while the other four factors amplified changes in such behavior. 1. Aggressive bank behavior The first factor that generated the bubble was the aggressive behavior of financial institutions. After 1987–88, it was clear that the behavior of financial institutions became extremely aggressive. If looked at more closely, such aggressive behavior on the part of financial institutions did not suddenly appear in the process of monetary easing in the latter half of the 1980s, but rather had already gradually started around 1983. a. Gradual financial deregulation and declining profitability of financial institutions Gradual financial deregulation and declining profitability are often mentioned as factors behind the change in the behavior of financial institutions (Figure 15).15 While Figure 15 Profitability of Japanese Banks 0.8 Percent Percent 20 0.6 15 0.4 10 0.2 5 0.0 0 –0.2 –5 –0.4 ROA (left scale) –10 –0.6 ROE (right scale) –15 –0.8 1964 66 –20 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 Notes: 1. Figures are for domestically licensed banks (summation of city banks, regional banks, regional banks II, trust banks, and long-term credit banks). 2. The definitions of ROA and ROE are as follows: ROA = (profit for the term)/(total assets – acceptances and guarantees), ROE = (profit for the term)/(total stockholders’ equity). Source: Japanese Bankers Association, Financial Statements of All Banks. 14. The mass media also played an important role in the transmission process of intensified bullish expectations. Shiller (2000) stated, “The history of speculative bubbles begins roughly with the advent of newspapers,” referring to the Dutch tulip mania of the 1630s as the first example of a bubble. 15. Arbitrage between domestic and foreign financial markets had already become active due to revision of the Foreign Exchange and Foreign Trade Control Law in 1980, abolition of restrictions on yen conversion in 1984, and the deregulation of interest rates which in effect had already started. Gradual deregulation of interest rates on deposits commenced from 1985, and various deregulation measures concerning the business activity of financial institutions and the securities market also started in the 1980s. 411 restrictions on fund-raising in the securities market by firms were removed from around 1980, banks were only allowed phased entry into the securities business and were very concerned that major firms would become less dependent on them for funding. In the meantime, the deregulation of interest rates on deposits proceeded gradually, forcing banks to pursue such aggressive lending as loans to small firms backed by property and also property-related loans at the expense of giving up the economic rent created by accepting deposits with regulated interest rates (Figure 16).16 As supporting evidence on this point, we compared the profitability, the growth rate of loans, and the ratio of property-related lending to total between seven failed banks and others among member banks of the Second Association of Regional Banks. It is confirmed that these failed banks were already exhibiting poor profitability in the first half of the 1980s and aggressively expanded their loans to property-related firms from the mid-1980s (Figure 17).17 b. Capital adequacy requirements Some point out capital adequacy requirements as a factor behind the aggressive behavior of financial institutions.18 The capital base of city banks, long-term credit banks, and trust banks was ¥35 trillion as of end-September 1988 and increased to ¥46 trillion as of end-September 1989 (Figure 18). The capital base was increased through several channels. First, it was increased by higher profits reflecting economic expansion during the bubble period. Second, Tier II capital increased reflecting unrealized capital gains on stockholdings. And third, banks increased equity financing because of favorable equity market conditions.19 Figure 16 Bank Lending to Real Estate Related Sectors 30 Percent 25 Non-banks 20 15 Real estate 10 5 Construction 0 1978 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 Notes: Real estate related industries correspond to real estate, construction, and non-banks. Source: Bank of Japan, Financial and Economic Statistics Monthly. 16. Hoshi and Kashyap (1999) pointed out that in the 1980s since major firms became less dependent on bank borrowings and a substantial portion of overall financial assets continued to be composed of bank deposits, banks sought new lending opportunities among small businesses and property-related firms, which resulted in an increase in nonperforming assets. 17. Hoshi (2001) showed, by using the financial statement data of individual banks, that the growth of nonperforming assets is closely correlated with the growth of loans to property-related firms, and that the growth of such loans is affected by the degree of losing their borrowers to capital markets as well as land price increases. 18. Risk-based capital adequacy requirements were agreed in 1988 and effected in Japan from fiscal 1992. 19. It should be noted that subordinated bonds are included in Tier II. 412 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons Figure 17 Profitability and Behavior of Failed Tier II Regional Banks [1] ROE Percent 11 [2] ROA Percent 0.35 10 0.30 9 8 0.25 7 6 0.20 5 4 Failed regional banks II 3 Existing regional banks II 0.15 Failed regional banks II Existing regional banks II 2 FY 1983 84 85 86 87 88 89 90 91 0.10 FY1983 84 85 86 87 88 89 90 91 [3] Growth Rate of Total Assets [4] Ratio of Loans to Real Estate 18 Percent 36 16 34 14 Percent Failed regional banks II Existing regional banks II 32 12 10 30 8 28 6 26 4 Failed regional banks II 2 Existing regional banks II 24 22 0 –2 FY1983 84 85 86 87 88 89 90 91 20 FY1983 84 85 86 87 88 89 90 91 Notes: 1. Tier II regional banks are member banks of the Second Association of Regional Banks. 2. Failed tier II regional banks are Taiheiyo, Tokyo Sowa, Kokumin, Niigata Chuo, Koufuku, Fukutoku, and Hyogo banks. Source: Japanese Bankers Association, Financial Statements of All Banks. The effect of an increase in the capital base due to unrealized capital gains on stockholdings has been hotly debated in the context of aggressive bank behavior during the bubble period. If banks had raised the capital base to the level of “economic capital,” which could have been used as a cushion against risks, it would be difficult to know whether the aggressive behavior of financial institutions was due to capital adequacy requirements or the result of recognizing risks on their part. In Japan’s economy during the bubble period, it thus appears more important to examine how financial institutions recognized and managed risks under gradual financial deregulation, rather than the effects of capital adequacy requirements. 413 Figure 18 Capital-Asset Ratios of Financial Institutions [1] Risk-Based Capital Adequacy Ratios and Capital Components 60 ¥ trillions Percent 12 50 10 40 8 30 6 4 20 Excess of Tier II (left scale) Tier II (left scale) Tier I (left scale) Risk-based capital adequacy ratio (right scale) 10 2 0 0 Mar. 1988 Mar. 89 Mar. 90 Mar. 91 Mar. 92 Mar. 93 Mar. 94 Mar. 95 Mar. 96 Mar. 97 Mar. 98 Mar. 99 [2] Amount Outstanding of Risk Assets ¥ trillions 450 400 350 300 250 200 150 100 50 0 Mar. 1988 Mar. 89 Mar. 90 Mar. 91 Mar. 92 Mar. 93 Mar. 94 Mar. 95 Mar. 96 Mar. 97 Mar. 98 Mar. 99 [3] Stock Prices and Unrealized Profits on Securities 35 30 25 ¥ thousands ¥ trillions Unrealized profits on securities (left scale) Nikkei 225 (right scale) 40 35 30 20 25 15 20 10 15 5 10 0 5 Mar. 1988 Mar. 89 Mar. 90 Mar. 91 Mar. 92 Mar. 93 Mar. 94 Mar. 95 Mar. 96 Mar. 97 Mar. 98 Mar. 99 Notes: 1. Figures are summation of 16 banks subject to international standards as of March 1999 among city banks, long-term credit banks, and trust banks. 2. Unrealized profits on securities correspond to 45 percent of the total, which can be included in the risk-based capital adequacy ratio. 3. Nikkei 225 comprises figures at the end of each period. Source: Japanese Bankers Association, Financial Statements of All Banks. 414 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons 2. Protracted monetary easing Protracted monetary easing is cited as the second factor behind the emergence of the bubble. In fact, from the 1980s major countries, including Japan, saw a high correlation between a rise in asset prices and the expansion of credit (Figure 19). There were three mechanisms through which monetary easing could lead to a rapid increase in asset prices. Figure 19 Real Aggregated Asset Prices and Credit [1] United States 180 [2] Japan 1980 = 100 1.4 Real aggregate asset prices Total private credit/ GDP ratio 160 260 160 Real aggregate asset prices Total private credit/ GDP ratio 240 1.3 [3] France 1980 = 100 220 1.2 1.1 200 1.2 140 180 1.1 120 1.0 160 1980 = 100 1.1 Real aggregate asset prices Total private credit/ GDP ratio 150 1.0 140 0.9 130 0.8 120 0.7 110 0.6 100 0.5 140 100 1.0 80 0.9 0.9 120 100 1970 75 80 85 90 0.8 1970 [4] United Kingdom 75 80 85 90 1.4 Real aggregate asset prices Total private credit/ GDP ratio 1.2 160 1.0 140 1.4 Real aggregate asset prices Total private credit/ GDP ratio 1.3 1.2 110 1.1 100 0.6 1.0 90 100 0.4 80 0.2 60 0.0 1970 75 80 85 90 0.8 70 1970 [7] Sweden 240 0.9 80 95 75 80 85 90 1.5 Real aggregate asset prices Total private credit/ GDP ratio 275 1.0 Real aggregate asset prices Total private credit/ GDP ratio 0.9 200 1.3 225 0.8 180 1.2 200 0.7 160 1.1 175 0.6 140 1.0 150 0.5 120 0.9 125 0.4 100 0.8 100 0.3 0.7 75 1970 75 80 85 90 95 0.2 1970 75 80 90 95 1.2 1.1 1.0 0.9 120 0.8 110 0.7 100 0.6 90 0.5 80 0.4 70 0.3 60 0.2 75 80 85 90 95 [9] Australia 1980 = 100 250 80 85 130 1970 1.4 220 80 Real aggregate asset prices Total private credit/ GDP ratio 140 95 [8] Finland 1980 = 100 75 160 1980 = 100 150 0.8 120 0.4 1970 [6] Netherlands 130 1980 = 100 120 90 95 [5] Canada 200 1980 = 100 180 80 95 85 90 95 130 1980 = 100 1.0 Real aggregate asset prices Total private credit/ GDP ratio 120 0.9 110 0.8 100 0.7 90 0.6 80 0.5 70 0.4 1970 75 80 85 90 95 Source: Bank for International Settlements (1998). 415 First, monetary easing could facilitate the funding of speculators by reducing funding costs (Iwamoto et al. [1999]). Since speculators who engage in large-scale investments tend to create positions in excess of their own financial resources, they usually need funds to cover a gap in settlement when trading a variety of financial assets. Protracted monetary easing from the latter half of the 1980s facilitated the creation of such investment positions by reducing funding costs. Second, a rise in stock prices, partly supported by monetary easing, reduced capital costs and facilitated financing in capital markets such as the issuance of new shares at market price as well as of convertible bonds and bonds with warrants. Third, a rise in land and stock prices increased the value of land and stocks held by firms, thereby enhancing their funding ability by increasing the collateral value of these assets. During the bubble period, it is true that the above three mechanisms worked. However, it is difficult to believe that the bubble was generated only through monetary easing. First of all, if monetary easing automatically induces a bubble economy, then why wasn’t it generated during all previous periods of monetary easing? In addition, why hasn’t a bubble emerged under such extreme monetary easing conditions as created by the zero interest rate policy since February 1999? Second, the fact that industrial countries simultaneously, albeit to a different extent, experienced a bubble economy from the latter half of the 1980s seems to imply that there might exist some common factors which generate bubbles.20 Considering all the above, it appears that monetary easing is a necessary but not a sufficient condition for the emergence of a bubble.21 3. Taxation and regulations The third factor behind the emergence of the bubble is taxation and regulations on land that tended to induce higher land prices.22 First is the effect of tax rates that are relatively low on the holding of land but heavy on land transactions. In general, when a rise in land prices is anticipated, the light tax burden on holding land has the effect of increasing the incentive to continue holding it, which thus suppresses the supply of land. Furthermore, the heavy tax burden on transaction gains has the effect of squeezing the supply of land by creating an incentive to delay selling it for as long as possible. The rise in land prices through such a mechanism reflected the expected present discount value stemming from the above tax advantage. Expectations for a rise in land prices increased the expected present discount value of the tax advantage, leading to a further rise in land prices. Second is the possibility that land prices, mainly in local areas, were formed by incorporating expectations that agricultural land would be converted to residential use in the future as a result of the lax application of regulations on land use. Like the tax effect just described, this suppressed the sale of land.23 20. Generally observed common factors in the bubbles of major industrial countries from the 1980s include monetary easing, the review of regulations and supervision not being concurrent with the progress of financial deregulation, and the distortion of taxation. 21. The relationship between monetary easing and the bubble is examined in more detail in Chapter IV. 22. For the effects of tax and regulations on land price formation, see, for example, Noguchi (1989) and Nishimura (1995). In the case of overseas, interest payments on housing loans being tax-deductible from income is pointed out as an important factor in land price formation (Shigemi [1995]). 23. When there is an incentive to hold land that can be sold at any time, it is likely to be left under-utilized. For example, Kanoh and Murase (1999) showed that the potential option value of the alternative utilization of land is an important determinant of land prices. 416 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons The rise in land prices due to the above factors can be regarded by landholders as the “institutional benefits” or “rents” created by the system. When land prices are rising, these institutional benefits become larger, which in turn accelerates the rise in land prices. 4. Weak mechanism to impose discipline As the fourth factor, it is pointed out that, while the behavior of many economic agents including financial institutions, firms, individuals, and the government became gradually aggressive during the bubble period, a mechanism to impose discipline on these agents was not functioning effectively. In Japan, the main bank system had been playing an important role in imposing discipline on firms, i.e., corporate governance. However, its functioning gradually weakened as major firms increased their funding through capital markets. In addition, the mechanism whereby discipline is imposed by shareholders and creditors did not function sufficiently due to such factors as cross-shareholdings, the application of the acquisition cost method of accounting, and insufficient disclosure.24 In light of the change in the environment as financial deregulation progressed, a new mechanism of corporate governance was needed for financial institutions. To this end, financial institution should have established a framework for controlling risks. Delay by the authorities in establishing an appropriate regulatory and supervisory framework made financial institutions rather lenient to review corporate governance on their part. Any mechanism imposing discipline on economic agents will change as the economy develops. A mechanism that is effective up to a certain point in time will gradually cease functioning adequately as the economic and financial environment changes. For example, the fact that Japan had not experienced the bankruptcy of financial institutions for a long time in the postwar period mirrors, in principle, the soundness of the financial system. The practice of cross-shareholdings enabled firms to be managed with emphasis on medium- to long-term managerial stability, which contributed to the strength of Japanese firms. Partly because of such success, there occurred a delay in establishing a new mechanism of discipline, which is perhaps partly responsible for the emergence of the bubble. 5. Self-confidence in Japan It appears that the above four factors are, albeit important, not quite sufficient to explain the emergence and expansion of the bubble. To further describe the expansion of the bubble, we need to introduce an additional factor, which we may term the self-confidence that prevailed in Japan at that time. Examining the backdrop against which such confidence was created, first is the fact that Japan’s economy continued to perform well. As we have seen from the movement of the yield spread on stocks, expectations became clearly bullish from the latter half of 1988, when Japan recovered from the aftermath of the stock price crash on Black Monday, and rises in both stock prices and economic growth were 24. As to the accounting standards, for example, convertible bonds and bonds with warrants are issued at a discount by an amount corresponding to stock conversion and stock purchase rights. Since the discount was treated inclusive of the issue price of bonds, it was regarded as a profit. 417 witnessed under price stability. Such good macroeconomic performance brought self-confidence to many economic agents. Second is the greater role of Japan in international financial markets. For example, Japan’s external claims substantially increased with the expansion of the current account surplus. The overseas activities of Japanese financial institutions expanded considerably and their share of international bank lending was 41 percent at the peak (in the fourth quarter of 1989). Large-scale takeovers of foreign companies by Japanese firms were frequently reported. An often-heard term, “the largest creditor country,” vividly captures the atmosphere of the time.25 Third, Japanese firms were leading the world in manufacturing technology, including semiconductors, and the success of Japanese-style management was regarded as evidence that it had a competitive edge over U.S.-style management. Finally, the rush of overseas financial institutions to Tokyo to open offices also supported Japan’s self-confidence, as evidenced by the term “Tokyo as an international financial center,” which was often used in the bubble period to describe the situation. In addition, such a rush to Tokyo pushed land prices higher through the increased demand for office space in the center of Tokyo, leading to the further intensification of bullish expectations.26 IV. Did the BOJ’s Monetary Policy Create the Bubble? The previous chapter described the mechanism behind the emergence of the bubble, and explained that protracted monetary easing was not the only factor, but one of several that generated the bubble. This chapter further examines in more detail the relationship between the emergence of the bubble and monetary policy. A. Monetary Policy during the Bubble Period In considering the relationship between the emergence of the bubble and monetary policy, it is useful to divide the bubble period from the latter half of the 1980s to the early 1990s into the following three sub-periods. The first sub-period is from the Plaza Agreement in September 1985 through the spring of 1987, during which period monetary easing was promoted to counter the recession caused by the rapid appreciation of the yen after the Plaza Agreement. The second sub-period is from the summer of 1987 to the spring of 1989. Although the BOJ sought an appropriate timing to tighten monetary policy during this sub-period, it could not easily shift to monetary tightening, thus resulting in the then lowest official discount rate being maintained for a protracted period. The third sub-period is from the spring of 1989, when the BOJ finally reversed its policy direction to monetary tightening. 25. The net position of U.S. external assets and liabilities became negative in the mid- to late-1980s (the exact timing of this turnaround slightly differs depending on the different evaluation of asset prices). In addition, it was in 1979 when both the English and Japanese editions of Ezra F. Vogel’s Japan as Number One were published. 26. The National Land Agency (1985) forecast that demand for office space in Tokyo would increase to a level equivalent to the office space contained in 250 skyscrapers. It is sometimes pointed out that this forecast could have had a significant impact on expectations with respect to future land prices at that time. 418 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons 1. Process of monetary easing In order to counter the recession brought about by the rapid appreciation of the yen after the Plaza Agreement in September 1985, the BOJ lowered the official discount rate five times for a total of 2.5 percentage points between January 1986 and February 1987 (Table 2). As a result, the discount rate of 2.5 percent, the then lowest, continued for about two years and three months from February 1987 to May 1989. There were three interrelated features of monetary policy during this period. a. Framework of international policy coordination The first feature was that monetary policy was strongly influenced by the framework of international policy coordination as exhibited in the Plaza Agreement of September 1985. The first pillar of the Agreement was coordinated intervention in the foreign exchange market to rectify the excessive appreciation of the U.S. dollar, and the second the international coordination of macroeconomic policy. Under such a framework of international policy coordination, countries with a current account surplus such as Japan and Germany were requested to boost domestic demand, while the United States, suffering from a current account deficit, was urged to make efforts to reduce its fiscal deficit (Table 3). Of the five reductions in the official discount rate after January 1986, only the first was at the pure instigation of the BOJ, the second through fifth being strongly influenced by the framework of international policy coordination as evidenced by the following fact: the second and third discount rate reductions were decided simultaneously in Japan and the United States and the other two incorporated in the joint statement of the Japanese-U.S. governments or the statement of the G-7. Therefore, a vague recognition that interest rates were decided upon consultation with relevant countries with due consideration given to international relationships became widespread among the public.27 Table 2 Reduction of Official Discount Rates Effective date Official discount rate Notes January 30, 1986 5.0 percent→4.5 percent March 10, 1986 4.5 percent→4.0 percent The announcement date was the same as that for the reduction of official discount rate by the FRB and Bundesbank. April 21, 1986 4.0 percent→3.5 percent The effective date was the same as that for the reduction of official discount rate by the FRB. November 1, 1986 3.5 percent→3.0 percent A joint announcement on the stability of foreign exchange rates by Finance Minister Miyazawa and Treasury Secretary Baker was published when the BOJ’s reduction of official discount rate was put into effect. February 23, 1987 3.0 percent→2.5 percent The Louvre Accord was agreed on the announcement date of the BOJ’s reduction of official discount rate. 27. Regarding the understanding of international policy coordination, former BOJ Governor Mieno said the mass media were haunted by the shadow of the Plaza Agreement, believing that policy coordination was to move interest rates simultaneously (Mieno [2000], p. 255). 419 Table 3 Plaza Agreement and Louvre Accord Plaza Agreement (September 22, 1985 in New York) 18. The Ministers and Governors agreed that exchange rates should play a role in adjusting external imbalances. In order to do this, exchange rates should better reflect fundamental economic conditions than has been the case. They believe that agreed policy actions must be implemented and reinforced to improve the fundamentals further, and that in view of the present and prospective changes in fundamentals, some further orderly appreciation of the main non-dollar currencies against the dollar is desirable. They stand ready to cooperate more closely to encourage this when to do so would be helpful. ... In particular, the Government of Japan will implement policies with the following explicit intentions. ... 3. Flexible management of monetary policy with due attention to the yen rate. ... Louvre Accord (February 22, 1987 in Paris) 10. The Ministers and Governors agreed that the substantial exchange rate changes since the Plaza Agreement will increasingly contribute to reducing external imbalances and have now brought their currencies within ranges broadly consistent with underlying economic fundamentals, given the policy commitments summarized in this statement. Further substantial exchange rate shifts among their currencies could damage growth and adjustment prospects in their countries. In current circumstances, therefore, they agreed to cooperate closely to foster stability of exchange rates around current levels. b. Preventing the appreciation of the yen The second feature was that considerable emphasis was given to ensuring foreign exchange rate stability, especially preventing the yen’s appreciation, in conducting monetary policy.28 This was against the backdrop of various anxieties such as the recession occasioned by the yen’s appreciation and the hollowing out of the domestic economy, reaching a point where preventing the yen’s appreciation became a national policy. Statements of the G-5/G-7 around that time referred to the policy intention of each country. Indeed, the relationship of monetary policy with the foreign exchange rate was emphasized in the Plaza Agreement statement, which said “[f ]lexible management of monetary policy with due attention to the yen rate” (Table 3). As a matter of fact, every time the official discount rate was lowered the statement issued by the Chairman of the Policy Board of the BOJ mentioned securing foreign exchange rate stability (Table 4). That the change in the official discount rate was strongly linked to the foreign exchange rate appeared to be especially true in the case of the rate reductions of October 1986 and February 1987. Of note is that monetary policy was used as a catalyst for several years after the Plaza Agreement to entice the United States into coordinated intervention in the 28. In changing the official discount rate after 1970, the foreign exchange rate was only mentioned as a policy objective when the discount rate was raised in 1979 and 1980 (following the second oil shock). When the foreign exchange rate began depreciating after 1988, interest rates were not raised. Monetary policy was implemented with emphasis not so much on foreign exchange rate stability but rather on containing the appreciation of the yen. 420 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons Table 4 Official Announcement of Policy Board Effective date Announcement (extract) January 29, 1986 The Bank of Japan hopes that this action will contribute to achieving domestic demand growth promoted by lower interest rates, and help correct Japan’s external imbalance. The Bank will continue to carefully watch the development of foreign exchange markets in future monetary policy management. March 7, 1986 Under such circumstances, the Bank of Japan decided it appropriate to lower its official discount rate. The Bank of Japan hopes that this action will contribute to limit extreme fluctuations of foreign exchange rate, and help correct Japan’s external imbalance by promoting growth in domestic demand. April 19, 1986 The Bank of Japan hopes that this action will contribute to achieving a more stable movement of foreign exchange rate, and, along with the economic stimulus package of the Government, promote an expansion of domestic demand and correct Japan’s external imbalance through such expansion. October 31, 1986 The Bank of Japan hopes that this action will contribute to sustained economic growth, and to this end, stability in foreign exchange rates is strongly desired. In the meantime, the Bank of Japan will continue to carefully watch the development of monetary easing, such as money supply, while maintaining price stability. February 20, 1987 The Bank of Japan hopes that this action, coupled with monetary easing up to now, will contribute to achieving stability in foreign exchange rates and steady growth in domestic demand. Recently, Japan and the United States reconfirmed the commitment to cooperate on various issues in foreign exchange markets, and close cooperation is thus far expected among industrial countries to promote stability in foreign exchange markets. The Bank of Japan will continue to carefully watch the development of monetary easing, such as the money supply. Note: Text is the authors’ translation from the original announcement in Japanese, with underlines added by the authors. foreign exchange market or to prevent high-ranking U.S. officials from “talking down the dollar.”29 c. Reducing the current account surplus by expanding domestic demand The third feature is related with the above two. Monetary policy was influenced by the economic policy agenda of the time that the current account surplus should be reduced by expanding domestic demand.30 Statements issued by the Chairman of the Policy Board were explicit on this point until the third discount rate reduction (Table 4). Needless to say, the reduction in the current account surplus through the expansion of domestic demand was pursued in such a way that did not conflict with the basic objective of the central bank to achieve price stability. Though this policy agenda was not mentioned with respect to the fourth and fifth reductions, it nevertheless considerably constrained the conduct of monetary policy by the BOJ. 29. See Funabashi (1988) for the process of how international policy coordination was implemented after the Plaza Agreement. 30. The so-called Mayekawa Report (Report of Studies Group on the Structural Adjustment for International Coordination) published in April 1986 most clearly described such a policy agenda. The background behind the strong concern of the Japanese government over the current account surplus was the adoption of retaliatory measures against Japan by the U.S. Senate in March 1985 and the drafting of protectionist legislation against Japanese products. With the expansion of the current account deficit in the United States, trade friction between Japan and the United States intensified, and protectionist moves to impose sanctions on Japan grew in the United States. 421 2. Seeking to shift to monetary tightening Economic recovery gradually became clear from around the spring of 1987.31 As money supply exhibited a large increase and asset prices soared, the BOJ began to take a cautious stance in conducting monetary policy. The following describes the process by which the BOJ sought an opportunity to shift to monetary tightening. a. Concern over excessive monetary easing The BOJ had already voiced concern over the massive increase in money supply and the rapid rise in asset prices in the summer of 1986, immediately after the third reduction in the discount rate. The concern of senior BOJ officials is expressed in the term “dry wood” (which can easily catch fire, i.e., easily ignite inflation), which was often heard at the time. In particular, when an increase in money supply and asset prices became rather marked after the fourth and fifth discount rate reductions, the statement issued by the Chairman of the Policy Board expressed strong concern over excessive monetary easing (Table 4). Against such a background, after the official discount rate was lowered to the then lowest rate of 2.5 percent in February 1987, the BOJ desired to raise interest rates as soon as possible, or at least to avoid a situation in which the conduct of monetary policy would be “constrained” (see Table 5 for monetary policy implementation during this period). However, the joint statement after the meeting between Prime Minister Nakasone and President Reagan in May 1987 referred to the BOJ’s short-term interest rate operations,32 which resulted in a further decline in short-term interest rates (the monthly average overnight unsecured call rate fell from 3.52 percent in April to 3.17 percent in May). Table 5 Transition Process to Monetary Tightening Date Related actions End-August, 1987 Encouragement of money market rates to rise October 19, 1987 Black Monday (New York stock market crash) October 20, 1987 Ease in the stance of money market operations January 13, 1988 U.S.–Japan joint announcement (Reagan and Takeshita) July–September, 1988 Gradual shift in the stance of money market operations for the direction of tightening (CD rate increased 0.7 percentage point from its latest bottom) November, 1988 Introduction of new framework of money market operations April 1, 1989 Introduction of consumption tax May 30, 1989 Increase in the official discount rate (2.5 percent→3.25 percent, effective date: May 31) 31. The BOJ expressed its view in its quarterly economic outlook of spring 1987 (BOJ [1987b]), saying that “as the effect of the appreciation of the yen in suppressing exports has gradually receded, and stock adjustment in response to the yen’s appreciation has progressed, it appears that the economy is, in cyclical terms, beginning to show firmness.” The EPA also revised its view slightly upward, saying that “the economy is becoming increasingly robust although the pace of recovery is slow” (authors’ translation). 32. The joint announcement on economic issues by Prime Minister Nakasone and President Reagan that was released after the meeting referred to the conduct of monetary policy as follows: “Prime Minister Nakasone outlined extraordinary measures to stimulate domestic demand in Japan, which included the already-introduced money market operations to lower short-term interest rates by the BOJ” (authors’ translation). 422 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons b. Raising the short-term interest rate in the summer of 1987 In view of the prospective hike in the official discount rate, the BOJ took the first concrete step to change its monetary easing stance at the end of August 1987 when it began guiding market interest rates to a higher level. As a result, short-term market rates gradually rose after September and, on October 19, immediately before Black Monday in the United States, the market rate on newly issued three-month CDs was 4.920 percent, 0.84 percentage point higher than the level at the end of August. Long-term interest rates also rose by nearly three percentage points compared with the lowest level, reflecting clear signs of economic recovery, an increase in money supply, and the rebound of commodity prices both domestically and overseas. However, Black Monday resulted in the BOJ suspending monetary operations to guide interest rates to a higher level, and short-term rates declined again. Under such circumstances, the maintenance of low short-term interest rates was mentioned in the joint statement issued after the meeting of Prime Minister Takeshita and President Reagan in January 1988.33 c. Call for “prudent lending attitude” At that time, the BOJ still maintained the framework of “window guidance” regarding the lending of commercial banks (moral suasion to contain the increase in loans) as a supplementary measure to orthodox monetary policy measures. Until the first quarter of 1987 the BOJ simply monitored the lending policy of commercial banks, but from the second quarter switched to moderate moral suasion urging commercial banks to maintain a “prudent lending attitude” and gradually strengthened the extent of moral suasion thereafter. In the situation where the official discount rate was unchanged, the BOJ could not conduct effective moral suasion on financial institutions to suppress lending, and even if it did lending would probably not have declined. On the other hand, if the BOJ did not effect strong moral suasion, there was a risk that the market would think the BOJ had no concern over the aggressive lending attitude of commercial banks. Under such circumstances, although the BOJ gradually strengthened window guidance with respect to the lending of commercial banks, more decisive policy action had to wait until the official discount rate was raised. d. Shift to monetary tightening in major overseas countries Immediately after Black Monday, financial markets and foreign exchange markets worldwide were unstable. Major foreign central banks lowered their interest rates and conducted monetary operations to provide ample liquidity to financial markets (see Table 6 for monetary policy in Germany and the United States at that time). Such monetary easing continued until the spring of 1988, but in the summer of the same year major overseas countries, including the United States and Germany, seeing clear signs of economic recovery, began raising interest rates again. In the foreign exchange market, the U.S. dollar reversed course and started to appreciate, and European countries conducted dollar selling intervention.34 33. In the joint announcement of Prime Minister Takeshita and President Reagan on economic issues, Japan’s monetary policy was described as follows: “In order to attain sustainable economic growth and to achieve foreign exchange rate stability, the BOJ has agreed to make efforts to maintain the current policy stance and low interest rates under price stability” (authors’ translation). 34. See Chapter V concerning the relationship between foreign exchange market intervention and monetary policy. 423 Table 6 U.S. and German Monetary Policy around the Time of Black Monday Date United States Germany September 4, 1987 Increase in official discount rate (5.5 percent→6.0 percent) September 23 Rise in repo rate (3.60 percent→3.65 percent) October 7 Rise in repo rate (3.65 percent→3.75 percent) October 14 Rise in repo rate (3.75 percent→3.85 percent) October 19 Stock price crash in the world markets (the so-called Black Monday). Central banks in each country provide ample liquidity to money markets. Mid-October to mid-November Reduction of FF rate (week of October 16, 7.59 percent→week of November 13, 6.72 percent) November 5 Reduction in Lombard rate (5.0 percent→ 4.5 percent, effective date: November 6) December 3 Reduction in official discount rate (3.0 percent→2.5 percent, effective date: December 5) After March 1988 Gradual shift back to tighter stance in money market operations June 30 Reduction in official discount rate (2.5 percent→3.0 percent, effective date: July 1) July 28 Reduction in Lombard rate (4.5 percent→ 5.0 percent, effective date: July 29) August 9 August 25 Increase in official discount rate (6.0 percent→6.5 percent) Increase in official discount rate (3.0 percent →3.5 percent, effective date: August 26) In Japan, short-term interest rates were under pressure to rise due to economic expansion, and short-term interest rates such as CD and Euro-yen rates increased. At that time, bill rates that adopted the quotation method were perceived by market participants as policy rates indicating the monetary policy stance and did not rise flexibly as the economy expanded. As a result, the outstanding amount of the bill market decreased rapidly from the spring to the fall of 1988. The BOJ adopted the so-called “new scheme for monetary control” in November 1988 and decided to completely liberalize interbank market rates, the main objective of which was to enhance the functioning of the interbank money market as well as break out of this situation. 3. Process leading to monetary tightening a. Shift to monetary tightening In 1989, the BOJ began seriously addressing the question of raising the official discount rate, but could not succeed in persuading the government or the general public on the need to tighten monetary policy.35 Though the background to this will 35. Following are two examples of articles on monetary policy appearing in major newspapers (authors’ translations): “Japan, the world’s largest creditor, should maintain low interest rates to the extent possible and strive to restore the framework of policy coordination among industrial countries” (Asahi Shimbun, February 26, 1989). “There is still a large discrepancy between inflationary concern in financial markets and actual price developments” (Nihon Keizai Shimbun, March 26, 1989). 424 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons be examined in more detail in the following chapter, the gist of the problem lay in the large difference of the evaluation of future inflationary pressure.36 For example, the quarterly economic outlook of the BOJ continued to express concern over inflationary pressure from the summer of 1988. On the other hand, the monthly economic report of the EPA consistently reiterated the view that consumer prices were stable even in 1989. Some argued against monetary tightening on the ground that raising interest rates would bring about a plunge in U.S. stock prices (which had seen stability restored) and a drastic fall in the U.S. dollar.37 It was in May 1989, a month after the introduction of the consumption tax, when the official discount rate was finally raised from 2.5 percent to 3.25 percent (Table 7). In raising the official discount rate, the BOJ strongly emphasized that it was a preventive measure against inflation (Table 8). b. Further monetary tightening The economy expanded rigorously even after the official discount rate was raised. Therefore, the official discount rate was raised again in October and December 1989, by 0.5 percentage point each time, and then two more times in March and August 1990. The two hikes in 1990 were relatively large, one percentage point in March and 0.75 percentage point in August (Table 7).38 Nevertheless, it took a considerable time for these hikes to have visible effects on money supply and asset prices including stock and land prices. In fact, the growth of money supply accelerated even after the official discount rate was raised and reached a peak in the second quarter of 1990, thereafter continuing to mark still double-digit growth until the fourth quarter.39 Stock prices continued to rise until end-1989, and in 1990 plummeted with a few rebounds on the way. Approximately one month after Table 7 Increase in the Official Discount Rate Effective date May 31, 1989 Official discount rate 2.5 percent→3.25 percent Notes The BOJ called for commercial banks’ “more disciplined management of their lending in terms of both quantity and quality” in the guidelines of “window guidance” for the period of June to September. October 11, 1989 3.25 percent→3.75 percent December 25, 1989 3.75 percent→4.25 percent March 20, 1990 4.25 percent→5.25 percent The MOF published an instruction on limiting real estate related bank lending in March. August 30, 1990 5.25 percent→6.0 percent Iraq’s invasion of Kuwait (the so-called Gulf Crisis) 36. One reason for lack of active discussion regarding inflationary pressure was that it was difficult to calmly discuss such a possibility prior to the introduction of the consumption tax. 37. Conflict between the United States and Germany regarding Germany’s interest rate hike in the summer of 1987 is sometimes held to be partly responsible for Black Monday, and can be cited as one reason for views opposing an interest rate hike in Japan. 38. One background factor behind the official discount rate hike in August 1990 was an increase in inflationary concern due to higher oil prices caused by Iraq’s invasion of Kuwait. 39. It was common practice at the time that money received in issuing CP was invested in large-lot time deposits to make a profit. This increased both financial assets and liabilities on the balance sheets of financial institutions and firms. 425 Table 8 Policy Board’s Official Announcements to Raise the Official Discount Rate Effective date Announcement (extract) May 30, 1989 The Bank of Japan considers that this action will contribute to achieving a continuing sustained growth promoted by domestic demand while maintaining price stability. The Bank also hopes that it will help correct Japan’s external imbalance and foster a healthy development of the world economy. October 11, 1989 The decision was taken to ensure an appropriate and flexible management of monetary policy with a view to the developments of foreign exchange rate, interest rates abroad, domestic business activity, prices, and money supply as well as a rise in market interest rates reflecting these developments. The Bank of Japan hopes that this action will contribute to a sustainable growth led by domestic demand while maintaining price stability. December 25, 1989 The decision was taken to ensure appropriate and flexible management of monetary policy with a view to the recent developments of domestic business activity, prices, the money supply, foreign exchange rate and interest rates abroad as well as a rise in market interest rates reflecting these developments. The Bank of Japan hopes that this measure will contribute to sustainable growth led by domestic demand while maintaining price stability. March 20, 1990 The decision was taken to ensure appropriate and flexible management of monetary policy with a view to the recent developments of domestic business activity, prices, the money supply, foreign exchange rate and interest rates abroad as well as a rise in market interest rates reflecting these developments. The Bank of Japan expects that this decision will contribute fully preemptively to maintaining price stability under the present circumstances. The Bank hopes that this measure will also contribute to sustainable growth led by domestic demand while maintaining market stability. August 30, 1990 The decision was taken to ensure appropriate and flexible management of monetary policy with a view to the recent developments of domestic economic activity, supply and demand condition of labor market, prices and the money supply as well as a rise in market interest rates reflecting these developments. It was based on the judgment that it would be necessary for the Bank of Japan to take a clearer stance to contain inflation. The Bank of Japan expects that this decision will prevent a resurgence of inflationary pressures, contribute to the financial market stability and continue providing for the conditions to maintain sustainable growth led by domestic demand. the official discount rate was raised in August 1990, stock prices had dropped to half the level of their peak. Land prices lagged stock prices in their descent but began to fall from around 1991. During this period, the economy continued to expand and peaked in February 1991 according to the EPA. In light of the three features of the bubble, 1990 saw the economy and money supply continue to expand while asset prices, at least partially, began to drop. With regard to monetary tightening after May 1989, let us look at the pace of monetary tightening and the speed at which it permeated the overall economy. The call rate, adjusted for inflation, had begun to rise substantially from end-1989, lagging the rise in the nominal call rate (top panel in Figure 20). With regard to the spread between long- and short-term interest rates, we began to observe an inverted yield curve, a typical pattern at times of monetary tightening, in 1991, although it had temporarily appeared in the latter half of 1989 (center panel in Figure 20). The lending attitude of financial institutions began to become constrained from the latter half of 1989 and in 1990 such restraint intensified considerably (bottom panel in Figure 20). 426 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons Figure 20 Real Short-Term Interest Rates, Spreads between Short/Long-Term Interest Rates, and Lending Attitude of Financial Institutions [1] Uncollateralized Overnight Call Rate Percent 14 Nominal Real 12 10 8 6 4 2 0 –2 1980 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 [2] Spreads between Short-/Long-Term Interest Rates 14 12 10 8 6 4 2 0 –2 –4 –6 Percent Spreads Call rate (overnight) JGB (10 years) 1980 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 [3] Lending Attitude of Financial Institutions 100 80 60 40 20 0 –20 –40 –60 –80 –100 “Accommodative” – “severe,” diffusion index percentage points Construction and real estate Non-manufacturing Manufacturing 1980 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 Notes: 1. Shaded areas indicate periods of economic expansion. 2. In calculating real uncollateralized overnight call rate, we employed CPI inflation adjusted for the impacts of introduction of consumption tax (April 1989) and increase in its rate (April 1997) based on the estimates of the Bank of Japan Research and Statistics Department. Sources: Bank of Japan, Financial and Economic Statistics Monthly ; Management and Coordination Agency, Consumer Price Index. 427 B. Relationship between Monetary Policy and the Emergence and Expansion of the Bubble 1. How did monetary policy bring about the bubble economy? First, let us consider how monetary policy became a factor in generating the bubble economy. In the previous chapter, a fall in funding costs, the expansion of equity financing, and an increase in collateral value were mentioned as the three mechanisms whereby monetary easing led to a rise in asset prices. Such mechanisms will always work under monetary easing, though the degree may differ. The most important point in considering the relationship between the emergence of the bubble and monetary policy is that as low interest rates were maintained under economic expansion, expectations that the then current low interest rate would indefinitely continue proliferated after a certain point in time, which led to strengthening the effects of the above three mechanisms on the rise in asset prices. Looking at the movement of implied forward rates from 1987 through 1989 (Figure 21), the yield curve flattened while the official discount rate was maintained at a low level.40 This suggests widespread market expectations that despite clear signs of economic expansion, the then current low interest rates would continue for an extended period and that there would be no difficulty in raising funds. It was in 1989 that the three characteristics of the bubble economy, namely, a rise in land and stock prices, the massive expansion of money supply and credit, and the overheating of economic activity, all progressed simultaneously and became most Figure 21 Implied Forward Rates 8 Percent 7 6 5 4 3 2 Official discount rate Forward rate (one-year) Forward rate (three-year) 1 Call rate (overnight) Forward rate (two-year) 0 1986 87 88 89 Source: Bank of Japan, Financial and Economic Statistics Monthly. 40. The implied forward rate is the future interest rate estimated from market rates with a different time-to-maturity. For example, the implied forward rate for three years ahead gradually increased from June 1987. As the BOJ conducted a slightly tighter monetary operation from September 1987, it rose to a level over 6 percent in the fall. However, such expectations for higher interest rates receded after the worldwide plunge of stock prices in October of the same year, and the implied forward rate decreased to around 5 percent. After the spring of 1988, the stock market gradually recovered and the economy once again showed clear signs of expansion. Nevertheless, the rate basically remained flat at around 5 percent toward the spring of 1989. 428 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons prominent. This seems consistent with the proliferation of expectations that then current low interest rates, which started from the summer of 1988, would continue for a prolonged period. 2. Could monetary policy have prevented the emergence of the bubble economy? The second question is whether monetary policy could have prevented the emergence of the bubble economy. If monetary policy were to focus solely on the “complete suppression of rises in asset prices,” such an objective could be achieved by significantly raising interest rates. In this rather extreme sense, monetary policy could have prevented the emergence of the bubble economy, or at least the emergence of the asset price bubble. In fact, Bernanke and Gertler (1999) conducted a simulation using data for Japan and calculated the ex post target interest rate that would have offset the stimulative effects of the asset price bubble (Figure 22). According to their calculation, if the target interest rate had been raised from around 4 percent to 8 percent in 1988, the emergence of the bubble could have been prevented.41 Even without such detailed simulation, there are many discussions in the same vein which maintain that the emergence of the bubble could have been prevented if monetary policy had been sufficiently tightened. Figure 22 Simulation by Bernanke-Gertler 12 Japan call money rate 10 12 10 8 8 Actual 6 6 4 4 2 2 0 0 –2 –2 Target –4 Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. 1984 85 86 87 88 89 90 91 92 93 94 95 96 97 –4 Source: Bernanke and Gertler (1999). 41. The simulation by Bernanke and Gertler (1999) shows that the target interest rate temporarily jumped in 1987 and 1997. Such temporary fluctuations in the target interest rate might perhaps reflect the effects of the introduction of the consumption tax (3 percent) in April 1989 and the hike in the consumption tax (from 3 percent to 5 percent) in 1997. 429 However, even if we had known ex ante the target interest rate that would have prevented the bubble from emerging, one wonders whether a central bank could have raised the short-term interest rate from 4 percent to 8 percent in one go at a time when inflation was very low (annualized inflation rate of the consumer price index [CPI] was 0.7 percent in 1988).42 During the bubble period, even though the BOJ advocated the need for monetary tightening, likening the economy to “dry wood which could ignite at any moment,” it could not succeed in persuading the public. Even if the BOJ believed that the emergence of a bubble was very likely, it is not clear if it would have been wise for the BOJ to raise interest rates to 8 percent when the BOJ was not sufficiently sure about the existence of the bubble. It thus appears difficult for monetary policy alone to prevent the emergence of a bubble. 3. Would earlier monetary tightening have reduced the scale of the bubble? The third question is whether we could have reduced the scale of the bubble if monetary policy had been tightened at an earlier stage. There are two opposing views on this. On the one hand, if monetary policy had been tightened at an early stage, the output gap would have narrowed, and the expansion of money supply and credit would have been suppressed, thus preventing the expansion of the bubble. On the other hand, if an early and small rise in interest rates had nipped inflationary pressure in the bud, it would have only further strengthened already bullish expectations, thus leading to the expansion of the bubble. Indeed, turmoil in the market following Black Monday was effective in calming market participants’ bullish expectations, but we cannot deny the possibility that by overcoming the turmoil bullish expectations were strengthened again, thus expanding the bubble. Our views on this are as follows.43 If interest rates had been raised early, expectations for the continuation of low interest rates would have receded more quickly than otherwise, and to that extent the timing of the autonomous collapse of the bubble would have been somewhat expedited. If this had transpired, the expansion of credit during the bubble period would likely have been suppressed and the negative effects after the bursting of the bubble smaller than otherwise. If interest rates had been raised early but only by a small degree, asset prices would have continued to rise, and thus the level of asset prices at the peak might not have differed much from the level if interest rates had not been raised early. In fact, bullish expectations intensified so much during the emergence and expansion of the bubble that a small rise in interest rates would have had little impact on such expectations. Under such circumstances, it is apparent that an increase in interest rates would have had to be fairly large to induce a change in market expectations. In other words, even if interest rates had been high, the effect of monetary tightening would not have materialized to any great degree until such expectations had been adjusted downward. If such expectations had been adjusted 42. BOJ Deputy Governor Yamaguchi questions the practical validity of the simulation result, saying “I don’t see how a central bank can increase the interest rate to 8 percent or 10 percent when we don’t have inflation at all” (Yamaguchi [1999]). 43. Kent and Lowe (1997) expressed similar views to those of the authors, emphasizing that an early rise in interest rates would heighten the possibility of the bubble bursting, thereby leading to smaller fluctuations in the real economy and inflation through smaller negative effects on the financial system after the bursting of the bubble. 430 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons downward, the adverse effects on the economy would inevitably have been quite large due to the combined effect of the rise in interest rates itself and the revision of expectations. Indeed, there is a strong possibility that the interest rate hike would have been large at the end of the bubble period, but this does not imply that it would have magnified the collapse of the bubble economy. 4. Should prudential regulations have been strengthened during the bubble period? The fourth question is whether we should have responded to the emergence and expansion of the bubble by tightening prudential regulations on financial institutions. There is a view that attributes the emergence and expansion of the bubble solely to an increase in financial institutions’ aggressive lending to the propertyrelated sector.44 Such a view leads us to the conclusion that an appropriate policy response during the bubble period would have been the strengthening of prudential regulations rather than monetary tightening. If the objective of prudential regulations was only to burst the bubble, propertyrelated lending could have been curbed through the strict regulation of the amount of loans. In this case, the rise in land prices would have been contained. In fact, the introduction of regulation on the total amount of property-related lending almost coincided with the bursting of the bubble.45 However, it is difficult to judge in advance whether a rise in land prices is a bubble or not and hence whether the regulatory and supervisory authorities should implement regulations on the total amount of lending. In addition, if such regulations are effected when there are strong expectations of a further rise in land prices, a number of loopholes to raise funds can be found, thus hampering the effectiveness of such regulations. Therefore, it would be desirable for the regulatory and supervisory authorities to avoid direct intervention, to the extent possible, in the lending policy of financial institutions, including lending to property-related firms. However, this does not mean to argue that it is meaningless for the central bank and supervisory authorities to attempt some preventive measures in the management of financial institutions. As we discuss in detail in Chapter VI, the problem during the bubble period was that credit had substantially expanded and had become greatly influenced by the movement of land prices. It is an important role of a central bank and supervisory authorities to accurately understand the existence and characteristics of risks accompanying aggressive lending and to explain them to the management of financial institutions. Although it might be difficult to draw a line between the explanation of risks and direct regulations as described above, it is nevertheless important for a central bank and supervisory authorities to recognize the difference between them. 44. See Yoshitomi (1998). 45. In the late 1980s, the Ministry of Finance (MOF) and the Japanese Bankers Associations issued quite a few directives and guidelines that warned about excessive property-related lending. In March 1990, MOF issued a directive and guideline that included the following two points: (1) For the time being, except for lending to public housing land development institutions, the MOF requests financial institutions to contain the increase in lending to property-related firms to within the increase in total lending. (2) For the time being, the MOF will collect reports with respect to lending to the real estate industry, construction industry, and non-banks. 431 V. Why Was Monetary Tightening Delayed? As described earlier, the BOJ sought an opportunity to tighten monetary policy long before the increase in the official discount rate in May 1989, but the start of actual monetary tightening was significantly delayed. We argued in the previous chapter that even if we had begun monetary tightening earlier, we could not have prevented the emergence of the bubble, though perhaps we could have expedited the timing of its bursting, thereby reducing its negative effects. This chapter examines the reasons why actual monetary tightening was delayed compared with the BOJ’s intention by looking at the economic and financial conditions, mainly after 1988. We adopt two approaches. The first looks back on various developments such as the increase in money supply that gave warning signals of the emergence of the bubble and examines why insufficient attention was paid to the above developments in the economic and financial environment. The second, putting aside individual warning signals, examines why it was difficult to tighten monetary policy by analyzing the then prevailing ideas with respect to the conduct of monetary policy. A. Ex Post Examination of Economic and Financial Conditions during the Bubble Period 1. Economic activity Upon reflection, at the time there did not exist sufficient recognition that monetary tightening was necessary, though the reasons for this might differ between the early and the latter part of the bubble period. During the early bubble period from 1987 to the first half of 1988, the strength of economic recovery was underestimated because of the following two reasons. First, the speed of the yen’s appreciation after the 1985 Plaza Agreement had been so rapid that there were serious concerns of recession and the “hollowing out” of the economy. However, what happened in fact was that the downward pressure on demand through the appreciation of the yen had already run its course, and the growth of the non-tradable goods sector, triggered by the change in relative prices and an increase in real income due to improved terms of trade, was materializing.46 Second, in forming public opinion, the manufacturing industry, which was susceptible to the deflationary impact of the yen’s appreciation, had a large say. Although the yen’s appreciation could work to bring about economic expansion led by non-manufacturing industries through lower import prices, the voice of non-manufacturing industries was not very loud. From the viewpoint of what generated the bubble, we should examine the assessment of the economy during the latter half of 1988. During this period, economic expansion became clear and the BOJ repeatedly gave warning signals that the economy was expanding beyond “cruising speed.”47 One reason for the warning 46. In analyzing the appreciation of the yen and economic adjustment in this period, the BOJ (1987) stated that “Japan’s economy has entered a stage in which the effects of the yen’s appreciation on demand are diminishing, while those on industrial structure due to the change in relative prices are gaining momentum” (authors’ translation). 47. For example, the BOJ (1989a) pointed out, in its quarterly economic outlook of January 1989, the risk that the economy might enter an adjustment phase due to upward pressures on prices. 432 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons was the constraint on resources as evidenced by the tightness of demand and supply, especially in the labor market (Figure 23). In addition, there was recognition of the risk that a large increase in business fixed investment would create excess capacity in the future, leading to an economic slowdown. However, these warnings were not viewed as sufficiently convincing. This was partly because prices were stable in spite of economic expansion. More fundamentally, there existed the prevailing recognition that productivity and the growth potential of Japan’s economy had increased. Many interpreted the high growth of business fixed investment as being due to the rising trend of the capital coefficient.48 Despite the rapid economic expansion, over-evaluation with respect to the mediumto long-term sustainability of economic growth proliferated. 2. Inflation While the most orthodox rationale for a shift to monetary tightening is the existence of inflationary pressure, extremely stable price developments at the time considerably weakened the recognition of the need to raise interest rates. For example, in the summer of 1988 when the United States and Germany raised interest rates, prices in Japan were extremely stable as witnessed by the year-on-year change in the domestic wholesale price index (WPI) and CPI for the third quarter being –0.7 percent and 0.2 percent, respectively.49 Figure 23 Labor Supply and Demand Conditions 3.5 Percent Times 2.0 Unemployment rate (left scale) 3.0 Ratio of job offers to applicants (right scale) Ratio of new job offers to new applicants (right scale) 2.5 1.8 1.6 1.4 1.2 2.0 1.0 1.5 0.8 0.6 1.0 0.4 0.5 0.2 0.0 1963 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 0.0 Sources: Management and Coordination Agency, Labour Force Survey ; Ministry of Labour, Report on Employment Service. 48. It is emphasized that a rise in the capital coefficient has been supported by not only investment for capacity expansion purposes but also for structural change such as research and development, information-related fields, and rationalization (for example, see the BOJ [1990b]). 49. It is often pointed out that one reason for stable prices under tight supply and demand conditions was the increase in merchandise imports from NIEs under the yen’s appreciation, which was termed the “safety bulb effect of imports.” (For example, see the BOJ [1989b, 1990b].) 433 Looking back, how can we assess the validity of “inflationary concerns” then expressed by the BOJ? There are three possible assessments, as follows. First, prices eventually rose substantially toward the end of the bubble period. The CPI had been stable until around 1987, started to rise gradually in 1988, and the year-on-year increase was 1.1 percent in March 1989, immediately before the introduction of the consumption tax (Figure 24). The year-on-year increase in the CPI, adjusted for the impact of consumption tax, continued to rise after April 1989, Figure 24 Price Development [1] Consumer Prices Percent 5 4 Changes from a year earlier 3 Annualized changes from a month earlier 2 1 0 –1 –2 1985 86 87 88 89 90 91 92 93 94 95 96 97 98 97 98 [2] Domestic Wholesale Prices 6 Percent 4 2 0 –2 –4 Changes from a year earlier Annualized changes from a month earlier –6 –8 –10 1985 86 87 88 89 90 91 92 93 94 95 96 Notes: 1. Figures are adjusted for the impact of consumption tax. 2. Regarding the CPI, annualized changes from a month earlier are computed from a seasonally adjusted series applied by the X-12-ARIMA with the options as follows: Estimation period: From January 1980 to December 1998 ARIMA model: (0 1 1)(0 1 1)12 Level adjustment: April 1989 (introduction of consumption tax) and April 1997 (consumption tax hike) 3. Regarding the WPI, annualized changes from a month earlier are threemonth moving average of the annualized month-to-month changes in the original series. Sources: Management and Coordination Agency, Consumer Price Index; Bank of Japan, Wholesale Price Indexes. 434 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons and it reached 2 percent in April 1990 and 3 percent in November 1990. In addition, the month-to-month annualized increase on a seasonally adjusted basis momentarily exceeded 4 percent in the latter half of 1990.50 In view of the fact that this 3–4 percent rise in inflation materialized despite a series of monetary tightening measures beginning with the official discount rate hike in May 1989, it is possible to conclude that inflationary concerns expressed by the BOJ materialized with a time lag of about two to three years. Second, inflationary pressure did not materialize after all and prices were generally stable during the bubble period. While it is true that the 3–4 percent inflation rate in the final phase of the bubble period was high compared with the present level of inflation, such a level cannot be regarded as particularly high compared with the figure before the bubble period, and thus we might be able to say that price stability had not been eroded. The third assessment emphasizes the importance of a long-term view with respect to price stability. If we take only the bubble period, prices could be perceived as stable. But if we include the period when the bubble bursts, we cannot say that prices were stable. During the period when the bubble burst, Japan’s economy experienced a decline in inflation and faced the risk of tumbling into a deflationary spiral (Figure 24). Such deflation very likely resulted from the bubble economy generated in the latter half of the 1980s. In this context, it seems more important to consider whether price stability is sustainable over the long run, instead of discussing whether prices had been stable during the bubble period. According to this view, it might be possible to assess that Japan’s economy did not succeed in sustaining price stability after the bubble period. Of the three possible assessments above, the first and second boil down to the question of what can be regarded as a tolerable inflation rate, and there can be a variety of answers. The experience of the bubble period seems to suggest the importance of the third point, which puts emphasis on the sustainability of price stability over a fairly long period. 3. Expansion of money supply and credit During the bubble period, it was the large increase in money supply and credit that signaled the need for an early rise in interest rates. In fact, as previously mentioned, while the BOJ expressed concern over this increase from a relatively early stage, it turned out that such concern was not sufficiently taken into account. The major reason for this was lack of a common understanding, including on the part of the BOJ, as to what kind of problems might be occasioned by the massive expansion of money supply and credit. At the time, concern over the large increase in money supply was mainly based on the view that such an increase would eventually lead to inflation. However, prices did not rise even though money supply increased, and a view that the statistical relationship between money supply and prices had become unstable gradually 50. In judging monetary policy operations, it is crucial to know when the expected inflation rate turned to increase. Higo (1999) has estimated the expected inflation rate and obtained the result that while it had moved parallel with, or with a time lag, vis-à-vis actual inflation until 1988, it increased rapidly preceding the increase in actual inflation from 1989 to 1990. 435 prevailed. In addition, the ongoing deregulation of deposit interest rates was often mentioned as a reason for the statistical instability.51 While an increase in money supply eventually affected prices to a certain extent, it had more conspicuous effects on the rise in asset prices. However, at the time, the rise in asset prices was mainly discussed from the viewpoint of equality of income and asset distribution, and was not seen as inducing large fluctuations in the economy from a medium- to long-term viewpoint. Accordingly, the large increase in money supply was not taken seriously.52 4. Rise in asset prices The rise in asset prices in general and land prices in particular, together with the increase in money supply was often cited as a rationale for an early interest rate hike during the bubble period. While the rise in asset prices was discussed from various viewpoints, the main focus was on the magnitude of so-called wealth effects on expenditure, the equality of asset and income distribution, and the risk of future inflation.53 While these points were important, the biggest problem stemming from the rapid rise in asset prices during the bubble period, in our view, was that it induced large fluctuations in economic activity, including the impact on the financial system, from a medium- to long-term viewpoint. However, there were only few arguments from such a viewpoint during the bubble period, and thus the rise in asset prices was not adequately taken as a warning signal in the conduct of monetary policy.54 B. The Influence of the Prevailing Policy Agenda In the previous section, we pointed out the difference in assessment regarding economic conditions and prices as a major reason the BOJ failed to make a convincing argument in favor of the need for an early interest rate hike. At the same time, it should 51. The BOJ (1988) pointed out that the relationship between prices and money supply had become unstable, and as background referred to the price stabilization effect stemming from the yen’s appreciation in addition to the effect of financial deregulation. In the United States, money supply ceased to be used as a policy target and its role in the conduct of monetary policy subsided substantially as the relationship between money supply and prices weakened in the process of financial deregulation. (For example, see Friedman [1997].) 52. The BOJ (1988) said that “while progress in monetary easing as witnessed by the large increase in money supply exerted multiple effects on the expansion of domestic demand and foreign exchange rate stability, one should be sufficiently aware of its side effects such that an increase in money supply will not lead to higher growth in the long run, but is accompanied by the risk of higher inflation,” and that “excessive monetary easing would induce problems from the viewpoint of the stability of money and capital markets as well as of social equality” (authors’ translation). 53. During the bubble period, many estimates were made regarding wealth effects on expenditure, with most of the results indicating that they were not so large. (For example, see the BOJ [1990a]). 54. In this regard, the BOJ (1990a) stated as follows in April 1990: Various economic agents appear to implicitly assume the “myth of ever-rising land prices,” which means that land prices will continue to rise, or, at least, never fall. However, recent episodes in foreign countries such as the United States and the United Kingdom show that the decline in land prices triggered the deterioration in the soundness of financial institutions. Lessons from these episodes can be summarized in the following three points: (1) A rapid increase in land prices in a short period of time could easily be reversed later on. (2) In this case, a decline in land prices could ignite financial difficulties at individual financial institutions, and, in the worst case, lead to the instability of the financial system as a whole. (3) Property-related firms defaulting on loans are most likely to be seen at small and medium-sized financial institutions and nonbanks. Although it is true that the factors behind the decline in land prices both at home and abroad, such as monetary tightening, changes in industrial organization, and changes in taxation and other institutional arrangements, are numerous and varied, they also indicate that the “myth of ever-rising land prices” is not infallible (authors’ translation). 436 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons be noted that this difference was also strongly influenced by the then prevailing orientation of economic policy, which may be termed the “policy agenda of the era” or the “policy paradigm.” 1. International policy coordination The most often-heard counterargument during the period after 1988 when the BOJ sought an opportunity to effect monetary tightening was that, against the backdrop of Japan being the world’s largest creditor and having a huge current account surplus, an interest rate hike in Japan would result in the collapse of international policy coordination.55 Originally, international policy coordination was a policy agenda whereby each country should contribute to sustained growth of the world economy by ensuring the stability of its own economy.56 However, the experience of the bubble period suggests that the term “international policy coordination” was often used by a country as rhetoric in forcing other countries to implement macroeconomic policy adjustment which they themselves should have already effected.57 The United States, after having corrected the excessive appreciation of the dollar at the Plaza Agreement, began to strongly urge other major countries to reduce interest rates for fear that further depreciation of the dollar might lead to its free-fall against the backdrop of a large budget deficit and current account deficit.58 It was unfortunate that, against the backdrop of concern over further depreciation of the dollar on the part of the United States and concern over recession due to the appreciation of the yen on the part of Japan, the maintenance of low interest rates with a domestic policy orientation was often discussed in Japan in the same light as international policy coordination. 2. Preventing the appreciation of the yen There are two views with respect to how the foreign exchange rate is placed in the conduct of monetary policy. The first is to conduct monetary policy so as to offset 55. Looking back, former BOJ Governor Mieno mentioned one background factor behind delayed monetary tightening: “Despite the appreciation of the yen, a reduction in the current account surplus which was regarded as an international pledge at the time did not progress as expected. Therefore, to raise interest rates and suppress domestic economic growth was regarded as contradicting the international pledge” (Mieno [2000], p. 206, authors’ translation). 56. Naturally, effects stemming from the economic policy of other countries are marginal compared with those of one’s own. For example, Taylor (1993), in estimating the Taylor rule by using a large macro model, estimated a policy rule by ignoring policy transmission effects from abroad. In addition, Komiya (1988), from the viewpoint of the effective assignment of macroeconomic policy instruments, argued that “all countries can simultaneously achieve all objectives most effectively when each country appropriately employs its domestic policy tools to achieve its own domestic goals.” In addition, Frankel and Rockett (1988) examined major world econometric models and pointed out that important policy multipliers differed not only in their value but also in terms of positives and negatives, and that if countries took a policy coordination action based on different models, we could not expect an improvement in the economic welfare of the countries concerned. 57. Former Governor Matsushita of the BOJ pointed out at a symposium in 1995 that “if a country pursues macroeconomic policy in coordination with other countries, favorable domestic economic conditions such as price stability and sustainable growth are likely to be sacrificed” (Matsushita [1995]). In addition, Feldstein (1988), based on his experience as the Chairman of the Council of Economic Advisers in the Reagan administration, pointed out that macroeconomic policy coordination is likely to make other countries a scapegoat or tends to serve as external pressure to change domestic policy. 58. In Congressional testimony based on the Humphrey-Hawkins Act in February 1986, former FRB Chairman Volcker emphasized that foreign countries need to expand their domestic economy, saying “The success of all our efforts is dependent in substantial part on complementary policies by other countries—their success in enhancing their growth and stability, in opening markets to others, and in helping to deal with points of strain in the international financial fabric.” As explained in Footnote 56, the improvement in the current account balance through economic expansion overseas is generally limited. 437 the effects of foreign exchange rate fluctuations on economic activity, and the second is to conduct monetary policy with the foreign exchange rate or a foreign exchange rate range as a direct target. The argument against an interest rate hike grounded on concern of an economic slowdown and the hollowing out of the domestic economy due to the appreciation of the yen centered around the first viewpoint. Though there are different views regarding the extent of the economic slowdown and the hollowing out of the domestic economy, there is no essential difference between those who advocate an early interest rate hike and those who oppose an interest rate hike concerning the perception that the effects of the foreign exchange rate need to be taken into account in the conduct of monetary policy. During the bubble period, it was a serious blow to the BOJ that many strongly argued that monetary policy should be conducted with the foreign exchange rate as a target.59 Under the situation where capital can freely move internationally, conducting monetary policy with the foreign exchange rate as a target means to abandon independent domestic monetary policy, which is neither possible nor appropriate for a large economy like Japan. However, under the circumstances where preventing the yen’s appreciation became a “national priority,” the fundamental problem was in the tendency to consider that the foreign exchange rate level could be controlled at will by monetary policy.60 As to the relationship between the foreign exchange rate and monetary policy, the role of foreign exchange intervention also became a topic of discussion. In Japan, the Ministry of Finance is responsible for foreign exchange intervention and the BOJ only conducts foreign exchange transactions as its agent.61 As a result, in some cases, foreign exchange intervention might not be effected in line with the stance of monetary policy. For example, when the BOJ was seeking monetary tightening, if it had conducted foreign exchange buying intervention as an agent of the Ministry of Finance in order to prevent the further appreciation of the yen, the policy stance of the BOJ would have been weakened and its policy intention perhaps misunderstood. In fact, after the spring of 1988 when the U.S. dollar reversed course and began to rise, European countries conducted U.S. dollar-selling intervention and turned to monetary tightening, but Japan did not intervene. We cannot deny the possibility that this was perceived as a signal of protracted monetary easing (Figure 25).62 59. The communiqué of the 1987 Louvre Accord stated “they agreed to cooperate closely to foster stability of exchange rates around current levels,” and it cannot be denied that such treatment of the foreign exchange rate became an obstacle for the subsequent conduct of monetary policy. 60. In general, it is known as the irreconcilable trinity of an open economy in international finance that, among three objectives, namely, independent monetary policy, free international capital flows, and fixing the foreign exchange rate, only two can be achieved simultaneously. 61. Based on the Consolidated Version of the Treaty Establishing the European Community, which stipulates that price stability is the objective for both monetary and foreign exchange rate policy, the European Central Bank conducts foreign exchange market intervention to the extent that it does not conflict with price stability. Regarding U.S. foreign exchange intervention in the 1980s, former FRB Chairman Volcker said it was a system with a mutual veto held by the Treasury and the Federal Reserve (Volcker and Gyoten [1992], p. 234). 62. As to the relationship between foreign exchange intervention policy and monetary policy at the time, Ohta (1991) said “it looked rather bizarre in the eyes of central banks in Europe, including the Bundesbank, to see Japan doing nothing while they were struggling to stop the appreciation of the U.S. dollar by intervening in the market” (p. 118, authors’ translation). 438 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons Figure 25 Foreign Exchange Market Intervention and Conduct of Monetary Policy [1] Yen/U.S. Dollar Rate and FX Market Intervention Yen/U.S. dollar ←Yen purchasing Yen selling→ ¥ trillions 2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 –0.2 –0.4 –0.6 –0.8 –1.0 –1.2 –1.4 –1.6 280 260 Amount of intervention (left scale) Yen/U.S. dollar rate (right scale) 240 220 200 180 160 140 120 100 1984 85 86 87 88 89 90 91 92 93 90 91 92 93 [2] Policy Interest Rates Percent 10 8 6 4 2 Official discount rate Call rate (uncollateralized, overnight) 0 1984 85 86 87 88 89 Notes: 1. Amounts of interventions are estimated from the supply and demand of funds in foreign exchange funds. 2. Call rates are concatenation of the following two rates: collateralized overnight rate before June 1985, and uncollateralized overnight rate after July 1985. Source: Bank of Japan, Financial and Economic Statistics Monthly. 3. Reducing the current account surplus through the expansion of domestic demand The policy agenda of reducing the current account surplus through the expansion of domestic demand also had quite a significant effect in supporting protracted monetary easing. 439 The current account balance is the difference between the export and import of goods and services, which can also be regarded as the difference between domestic savings and investment. The difference between savings and investment of a country reflects not only cyclical factors but also its long-term trend.63 Japan’s current account surplus reached 2.1 percent of nominal GDP in the 1980s and, roughly speaking, the difference between savings and investment over the long term is likely of this magnitude (Figure 26).64 When a current account surplus basically stems from long-term excess savings, the expansion of domestic demand cannot result in a substantial reduction in the surplus. However, in Japan there still remained strong pressure for the reduction of the surplus through the expansion of domestic demand. Indeed, many called for a reduction in the current account surplus that went beyond what was justified by cyclical factors. This policy agenda was a powerful argument against an early discount rate hike. 4. Relationship with fiscal policy When we examine the conduct of monetary policy during the bubble period in relation to the then prevailing policy agenda, the relationship with fiscal policy is also an issue for discussion. In this regard, the most often-heard argument was that the delay in the implementation of expansionary fiscal policy increased the burden on monetary policy which resulted in excessive monetary easing, thus generating the bubble.65 Indeed, it is true that the government was cautious in implementing expansionary fiscal policy during the first half of the bubble period from the viewpoint of fiscal consolidation, and that the expansion of domestic demand was mainly borne by monetary policy (Figure 27).66 It is often argued that, if expansionary fiscal policy had been implemented at an earlier stage, the official discount rate might not have been reduced to 2.5 percent. However, as we examined, the essential issue for monetary policy during the bubble period was not low interest rates per se but rather the creation of expectations that low interest rates would continue for a protracted period under economic expansion. Therefore, the point of discussion is whether an early implementation of expansionary fiscal policy facilitated a policy shift to monetary tightening. If such a shift in monetary policy was difficult in any case, the argument that the bubble would not have emerged if expansionary fiscal policy had been effected earlier will not hold. 63. See, for example, Komiya (1994). 64. Ueda (1988, 1992) pointed out, based on an estimation of the current account balance function, that Japan’s structural current account surplus reached some 3 percent of nominal GDP in the first half of the 1980s, mainly because of an increase in the U.S. government deficit and a decrease in Japan’s government deficit. 65. It is natural that the fiscal authorities put emphasis on fiscal consolidation. However, the question is whether fiscal consolidation is achieved through sustainable measures. The bubble period had seen an increase in tax revenue (corporate, income, inheritance, securities transaction tax, etc.) not only due to economic expansion and the rise in asset prices but also a temporary increase in revenues stemming from such factors as the sale of NTT shares and the issuance of commemorative coins. However, tax revenue had not increased if we include the bursting of the bubble period, and fiscal consolidation was not truly achieved. The BOJ (1989b) estimated that the increase in tax revenue due to the bubble was about ¥7.5 trillion (5.4 percent of tax revenue and stamp duties) for three years from fiscal 1986 to 1988. 66. The contribution of public demand to the growth rate of real GDP consistently declined from 1986 through 1989 as follows: 0.8 percent, 0.5 percent, 0.5 percent, and 0.2 percent. 440 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons Figure 26 Ratio of Current Account to Nominal GDP 5 Ratio to nominal GDP, percent Moving average for past 10 years 4 3 1970s 0.8% 2 1990s 2.4% 1980s 2.1% 1 0 –1 –2 1970 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 Note: Figures for current account are concatenation of current and previous basis data by adjusting the average from 1985 to 1995 when both basis data are available. Sources: Bank of Japan, Balance of Payments Monthly ; Economic Planning Agency, Annual Report on National Accounts. Figure 27 Fiscal Balances in Japan, United States, and Germany Ratio to nominal GDP, percent 4 United States Japan Germany 2 0 Forecasts –2 –4 –6 –8 –10 1983 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 Notes: 1. Figures after 1999 are forecasts. 2. Figures for Germany are concatenation of the following two series: West Germany before 1990, and unified Germany after 1991. Sources: Organisation for Economic Co-operation and Development, Economic Outlook, various issues. The point of discussion above boils down to the question as to what extent the independence of the BOJ had been assured during the bubble period. Even under the old Bank of Japan Law, the change in the official discount rate was determined exclusively by the Policy Board and the BOJ retained independence in monetary policy. However, the BOJ was also under the broad supervision of the government 441 (the Ministry of Finance) which is responsible for fiscal policy, and the possibility cannot be denied a priori that such supervision might have affected the independence of monetary policy. Under the old law, the BOJ maintained that it had “de facto independence.”67 The new Bank of Japan Law was put into effect in April 1998, and the independence and accountability of the BOJ were strengthened in various respects.68 Experience under the new law so far seems to suggest the importance of independence and accountability that are legally spelled out. C. Recognizing the Adverse Effects of the Bubble To summarize the discussions regarding the delay in monetary tightening, we conclude that we had insufficient recognition of the magnitude of damage caused by the bursting of the bubble, which was disproportionately larger than the gains obtained in the emergence and expansion of the bubble.69 If we analyze the adverse effects of the bubble with the benefit of hindsight after the bursting of the bubble, the largest adverse effect would be that it induced a prolonged recession through the following three mechanisms. Among these three, while the first works symmetrically between the period of the emergence and expansion of the bubble and the period of the bursting of the bubble, the effects of the second and third mechanisms are disproportionately larger during the period of the bursting of the bubble. The first mechanism is a decline in economic activity accompanying the correction of bullish expectations. For example, we can point out the reversed wealth effects on expenditure and classical stock adjustment as a result of excessive investment during the bubble period. The second mechanism is a reduction in the economic value of capital equipment and reduced supply capacity. During the bubble period, capital expenditures dramatically increased on the premise of a future rise in asset prices and the underlying pattern of demand. The economic value of such physical assets fell sharply because they were unlikely to be utilized in the future and it would have been costly to convert them to different uses. In particular, considering that in the 1990s major industrial countries expanded their economies by taking advantage of innovation in information and telecommunications technology, the question of which areas had 67. Regarding independence of the BOJ at the time, the Institute for Monetary and Economic Studies of the BOJ (1986) stated that “under the current law, the BOJ is widely under the supervision of the Ministry of Finance. Individual items subject to supervision are stipulated in detail, and the Ministry of Finance retains the right to issue general business directives and supervisory ordinances as well as to dismiss senior management . . . . However, since the Bank always maintains close contact and a cooperative relationship with the government, the above-mentioned right has never been exercised and, in fact, monetary policy has been conducted independently under the sole responsibility of the Bank of Japan” (p. 445, authors’ translation). 68. For example, independence was strengthened and the transparency of policy decision making mandated legally. First, the wide-ranging right of the government to issue general business directives was abolished and the right of the government became limited to supervision of compliance with laws and articles of association. Second, the reasons for the dismissal of senior management are confined to those such as bankruptcy, physical and mental disorders, and imprisonment. Third, if the Minister of Finance does not approve the operational budget of the BOJ, the Minister must publish the reasons. Fourth, monetary policy directives are to be decided by a majority vote at Monetary Policy Meetings accompanied by a high degree of transparency with detailed minutes published after meetings. 69. The IMF (1989, 1990) expressed an optimistic view of the future course of economic developments in Japan, saying that both high economic growth and price stability could be achieved through appropriate economic policy management. 442 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons been the recipients of business fixed investment during the bubble period in Japan turned out to be of the utmost significance. In this context, we should recognize that the serious dynamic resource misallocation caused by misguided prices during the bubble period was a mechanism inducing economic stagnation.70 The third and the most important mechanism is a so-called balance-sheet adjustment, in which a fall in asset prices eroded the asset quality of both lenders and borrowers, and reduced credit availability through the erosion of capital base, leading to a decline in economic activity. The capital base functions as a buffer against future risks and losses. Such a function is not clearly recognized as long as the economy is expanding smoothly. The effects of a capital base shortage will materialize once the outlook for economic expansion changes. After the bursting of the bubble, as asset prices fell and the capital base was substantially reduced, the possibility of bankruptcy increased among financial institutions, firms, and individuals. Under such circumstances, economic agents whose capital base had been eroded became cautious in taking on risks and also in doing business with counterparties whose capital base had been eroded.71 VI. Lessons for the Bank of Japan As explained in the preceding chapters, a bubble is defined as a phenomenon in which expectations become extremely bullish as various factors work in a complex manner. As such, we may not be able to completely prevent the emergence of a bubble. The most orthodox approach is to build into the economic fabric a mechanism of self-restraint, recognizing that bullish expectations might sometimes intensify to the extreme. In this chapter, we intend to draw four lessons for central banks, bearing in mind the importance of self-restraint in responding to a bubble. A. Importance of Forward-Looking Monetary Policy The most significant lesson that central banks have learnt from the emergence of bubble economies is the importance of conducting monetary policy in such a forward-looking manner that it is possible to grasp the potential risk to the economy as early as possible. As evidenced by the experience of Japan’s bubble period, a bubble is not generated suddenly, but expands as it gradually accumulates energy. Therefore, it is important to deal with a possible bubble in a preemptive manner with a view to the future risk of inflation rather than to make a belated response only after inflation or the existence of a bubble visibly materializes. Perhaps monetary policy alone cannot 70. While the first mechanism materializes mainly from the demand side, the second comes mainly from the supply side. 71. Bernanke, Gertler, and Gilchrist (1996) advocate a “financial accelerator” theory, where a vicious circle between a decline in asset prices and a decline in demand will be created if information asymmetry exists between those who supply funds and those who demand funds. Balance-sheet adjustment is regarded as reflecting a more cautious lending attitude on the part of financial institutions from the viewpoint of firms, and as a more cautious investment attitude on the part of firms and a decline in demand for funds from the viewpoint of financial institutions. 443 prevent a bubble from emerging. However, if monetary policy were conducted in a forward-looking manner, economic fluctuations would be smaller.72 Needless to say, in the very process of the expansion of a bubble, it is difficult to identify whether it is really a bubble or not. One reason for this is the possibility that the economic structure might be undergoing change. When productivity is rising reflecting a change in economic structure, strong monetary tightening based on the assumption that the economic structure has not changed would constrain economic growth potential. In such a case, the central bank is faced with two different kinds of risks. This issue can be regarded as similar to a problem of statistical errors in the test procedure of statistical inference. Put metaphorically, Type I error (erroneously reject a hypothesis when it is true) corresponds to a case where (though a “New Economy” theory may be correct) rejecting the theory means the central bank erroneously tightens monetary conditions and suppresses economic growth potential. Type II error (failure to reject a hypothesis when it is false) corresponds to a case in which a bubble is mistaken as a transitionary process to a “New Economy,” and the central bank allows inflation to ignite. Given that one cannot accurately tell in advance which one of the two statistical errors the central bank is more likely to make, it is important in the conduct of monetary policy to consider not only the probability of making an error but also the relative cost of each error. Based on the experience of Japan’s bubble period, it is important for the central bank to recognize that making the Type II error is fatal compared with the Type I error when faced with bubble-like phenomena. Of course, a comparison of risks inherent in the two types of errors does not necessarily imply that monetary policy should be conducted by considering only the more fatal risk. Even though the risk of a bubble is regarded as more fatal, we should perhaps choose a gradual tightening rather than a rapid tightening in the conduct of monetary policy.73 However, even in such a case, we should take a pragmatic approach to flexibly select the degree of tightening while paying due attention to not only Type II error but also Type I error. How should a forward-looking monetary policy be conducted? The answer is to conduct monetary policy with emphasis on maintaining an environment conducive to sustainable economic growth, which is the ultimate goal of price stability. A favorable environment presumes both price stability and financial system stability. Price stability, which monetary policy should aim at, is not stability at any particular point in time but rather sustainable stability that can support economic growth over the medium to long term. Therefore, even when measured inflation is stable, it will become necessary to raise interest rates promptly to ensure sustainable 72. There may be a case where the market would respond before the central bank if it was thought the central bank would act in a preemptive manner. In this case, the central bank would follow market movements to change the policy rate. 73. Brainard (1967) points out that if there is uncertainty with respect to the multiplier effect of economic policy measures, then the authorities should adopt a conservative approach. See also Blinder (1998) on this point. However, Stock (1998), by using a small U.S. model, contends that it is desirable to adopt an aggressive policy rule when the economy is undergoing structural change. 444 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons price stability if the risk of such stability being impaired is judged to be increasing.74 Monetary policy also influences the financial system through the behavior of financial institutions and macroeconomic conditions. To achieve financial system stability, it is important to maintain not only a favorable macroeconomic environment but also the soundness of individual financial institutions. In this regard, the regulatory and supervisory authorities play an important role. Thus, it should be noted that, although financial system stability is an important policy objective for the central bank, it should be recognized that the central bank does not command the same power of influence over this objective as it does over price stability when trying to maintain a favorable environment. B. Grasping the Risk Profile of the Economy The second lesson of the bubble economy is the importance of recognizing the risk profile of the economy as a whole, which might adversely affect price stability and financial system stability from the medium- to long-term viewpoint. No rules exist regarding how to recognize risks. Based on the experience of Japan’s bubble period, we should examine the issue from the following five perspectives: the output gap in the economy, money supply and credit, asset prices, the behavior of financial institutions, and the interaction of various risks. 1. Output gap In the bubble period, the overheating of the real economy was most vividly evidenced by labor market and capacity utilization data. Of course, there is a lag between the tightening in the labor market and capacity utilization, and a rise in wages and prices. However, as it is not easy to increase capacity in the short run, the economy should be carefully monitored when the output gap narrows. 2. Money supply and credit In the bubble period, we could have extracted useful information from such data as an increase in money supply and credit. After the 1970s, money supply fluctuated widely on two occasions: in the first half of the 1970s when the yen appreciated and the first oil crisis occurred, and after the latter half of the 1980s. These two occasions coincided with periods of considerable fluctuations in prices in general as well as asset prices (except for the period when the second oil crisis occurred). Furthermore, during these two periods, real economic growth rates also experienced large fluctuations. At present, no consensus exists among central banks concerning how to place money supply in the conduct of monetary policy. Based on past experience, including the bubble period, when money supply and credit show a very large upswing, we should pay close attention to such movements in the conduct of monetary policy on the presumption that large fluctuations in these indices may indicate the possibility of undesirable changes in economic activity. 74. FRB Chairman Greenspan discusses the definition of price stability that monetary policy should pursue and referred to an operating definition of price stability from a central banker’s point of view: “Price stability obtains when economic agents no longer take account of the prospective change in the general price level in their economic decision making” (Greenspan [1996]). See Shiratsuka (1997) for discussion on the definition of price stability as the target of monetary policy. 445 3. Asset prices Monetary policy cannot control the level of asset prices. If it dared to do so, it would amplify fluctuations in economic activity. Nevertheless, we should recognize the importance of asset prices in the conduct of monetary policy because they influence monetary policy in a variety of ways. First, asset prices affect expenditures through wealth effects. Second, they contain valuable information about expectations regarding the future economic outlook. If we make use of asset prices in obtaining information, we must be mindful of the fact that a change in asset prices reflects not only the inflationary expectations of private economic agents but also other factors such as phenomena similar to the bubble and structural change in the economy.75 Third, a change in asset prices may have a huge impact on financial system stability and, in due course, on economic activity as a whole.76 As Kindleberger (1995) points out, there are no cookbook rules to deal with asset prices.77 However, we think it important to accurately analyze changes in asset prices and examine whether the expectations implied are sustainable in relation to the course of the overall economy, bearing the above three viewpoints in mind. 4. Behavior of financial institutions The expansion of a bubble accompanies the expansion of money supply and credit. One cannot judge whether the expansion of money supply and credit is compatible with sustainable economic growth just by looking at growth rates of money supply and credit. To evaluate the nature of expansion, the content has to be taken into consideration. For example, borrowing costs and covenant clauses such as collateral requirements, types of collateral and haircut rates are important. Another important point is how an increase in bank liabilities, i.e., money supply, corresponds to an increase in the assets of financial institutions. During the bubble period in Japan, money supply and credit were discussed from quantitative viewpoints. But we also need to monitor the credit creation behavior of financial institutions and analyze how it might affect the economy. 5. Interaction of risks In retrospect, during the bubble period financial institutions took risks that were out of proportion to expected profits. There was lack of recognition about risks related to the economy as a whole and the financial system, especially the concentration and interaction of risks. The interaction of risks takes various forms. First, let us look at the interaction of risks among different but related industries. For example, during the bubble period the high profitability of computer-related industries owed greatly to large computerrelated investments by financial institutions. Such investments, triggered by financial 75. Shiratsuka (1999) examines the possibility of incorporating asset prices in the price index. He concludes that it is very difficult to construct a price index which includes asset prices for the following reasons: accuracy and coverage of asset price statistics are low; changes in asset prices depend on various factors; they are also significantly influenced by economic and financial developments. 76. For example, the possibility of utilizing information, which can be extracted from derivatives markets and other financial markets, is one important issue to be examined (see Nakamura and Shiratsuka [1999]). 77. Kindleberger (1995) said on this point that “When speculation threatens substantial rises in asset prices, with a possible collapse in asset markets later, and harm to the financial system, or if domestic conditions call for one sort of policy, and international goals another, monetary authorities confront a dilemma calling for judgment, not cookbook rules of the game. It is, I believe, realistic.” 446 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001 The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons globalization and the progress of technological innovation, were also closely related to a rise in asset prices. Under these circumstances, the economy tended to be influenced by a larger increase in asset prices than generally thought. Second, risks arising from the correlation between loan value and collateral value can be pointed out. During the bubble period, real estate and stocks were often accepted as collateral. However, if the profitability of businesses financed by secured loans is closely related to collateral value, such loans become practically unsecured since profits and collateral value move in the same direction. These aggregate risks are not merely the sum of risks recognized by individual economic agents. Here, the interaction of various risks plays an important role. In addition, the interaction of risks may arise between financial and nonfinancial sectors. Therefore, a perspective that recognizes aggregate risks is quite important, and it becomes crucial which risk factor should be watched under evolving economic and financial conditions. The BOJ gathers information regarding the economy and financial system through its examination and monitoring of financial institutions and also through daily dialogue with financial market participants. The BOJ is well positioned to grasp the risk profile of the economy, which may adversely affect sustainable economic growth, by taking advantage of such information. C. Relationship with the Prevailing Policy Agenda The third lesson we have learnt from the bubble period is the importance of working on the policy agenda. In Chapter V, we described three policy agenda items, namely, international policy coordination, preventing the appreciation of the yen, and a reduction in the current account surplus by expanding domestic demand, which constrained the conduct of monetary policy during the bubble period. We also explained the relationship with fiscal policy. Although various agenda that may be detrimental to the fundamental mission of the central bank may surface depending on economic conditions at the time, it will be difficult for the conduct of monetary policy to be immune from any particular policy agenda once it proliferates. Hence, it is important for the central bank to constantly express its views on key policy items. D. Importance of Designing an Appropriate Institutional Framework The fourth and last lesson from the bubble period is the need to design an appropriate institutional framework. Monetary policy influences the decisions and behavior of private economic agents through interest rates and liquidity. But the degree of influence depends on the institutional framework, such as the supervision of financial institutions, taxation, the regulatory framework, accounting system, and legal infrastructure. Considering the experience during the bubble period in Japan, if financial deregulation had progressed at an earlier stage, and if the regulatory and supervisory framework had been modified in line with the changes in financial markets, the behavior of financial institutions would probably have been different to some extent. If taxation on land had not been biased toward accelerating an increase in land prices, the degree of increase in land prices would have been different. If the BOJ had 447 implemented reform measures with respect to the short-term money market and window guidance at an earlier stage, as we touched upon in Chapter IV, economic developments might have been slightly better. If an institutional framework is likely to adversely affect sustainable price stability and financial system stability, the BOJ should analyze the macroeconomic impact and make known its views to the public, even if the BOJ is not directly responsible for designing the institutional framework. At the same time, it is important that the BOJ should make efforts to review and modify, if necessary, any institutional framework for which it is primarily responsible as the economic and financial environment changes. References Bank for International Settlements, 63rd Annual Report, 1993. ———, Quarterly Review: International Banking and Financial Market Developments, August 1999. 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